Why bonds are safer than stocks?

[goodrookie]

If a corporation is having hard time which is reflected in its downward stock price, why would bonds issued by that corporation be safer? (Yes, I know in bankruptcy bonds take precedence.) I do not understand why people think bonds is a wonderful thing to have as a protection against market crash.

[innerscorecard]

Bond holders are protected in their debt payments by legally enforceable contracts. Owners of common stocks, on the other hand, own the residual value of the company after debt claims, which may not be very much when times aren't good.

[Dodge]

I do not understand why people think bonds is a wonderful thing to have as a protection against market crash.

Because they are protection against market crash:



The blue line is the total stock market index fund, the orange line is the total bond market index fund.  It's a very smooth ride, unaffected by the stock market crashes.

[goodrookie]

@Dodge: Points taken. I am not arguing against the data. But why is it so? Why bond funds do not have the volatility?

[Left]

the way i view it is that bonds are actual assets of the company, ie they have to pay it or bond holders repossess the company. while stocks come out of the profits and if they dont have any profits then they have nothing to pay with.

like a home mortgage vs paying the lawn caretaker, if you dont pay on house you lose it. if you dont pay for grass to be cut, house just looks bad but you dont lose it.

i might be wrong but its how i view bonds.

[innerscorecard]

@Dodge: Points taken. I am not arguing against the data. But why is it so? Why bond funds do not have the volatility?

Because bond holders are protected in their debt payments by legally enforceable contracts. Owners of common stocks, on the other hand, own the residual value of the company after debt claims, which may not be very much when times aren't good.

[clifp]

@Dodge: Points taken. I am not arguing against the data. But why is it so? Why bond funds do not have the volatility?

It is a risk vs reward situation. For instance in 2009, 140 banks failed and were closed by regulators, in most cases they were taken over by other banks, in some case they were simply shut down.

In almost all cases the stock holders were were wiped out and they lost 100% of their investment.  AFAIK the bond holders never lost more than 20% of their investment and many cases their principal was repay in full in the case of senior debt.

[hodedofome]

On the upside, investment grade bond holders don't get rewarded with extra interest payments if the company makes more money. But stock holders might get more dividends. It's just less volatility all around because they have less risk on the downside and less reward on the upside. 

You also see, in most past time periods, that bonds are a safe haven when stocks are doing poorly. That's people's perception as much as anything else. So bonds get bid up in bear markets because people view it as being a safe place to put their money.

[humblefi]

I like the thought about a better legal entitlement for bonds than stocks.

I have another hypothesis. Lets assume that the number of people who want to buy stocks is much more than the number of people who want to buy bonds.
If this is so, then the demand for stocks is much higher than bonds and people bid up the stock price i.e. the stock price can climb up the wall much much faster and higher than a bond...especially, since the current feeling is that stocks can make more money than bonds. If the price climbs were unjustified, then the fall is also quick and ugly....the alternate impression created is that bonds do not fall that much and are safer.

What do you folks think about this hypothesis?

[Dodge]

I have another hypothesis. Lets assume that the number of people who want to buy stocks is much more than the number of people who want to buy bonds.

Although the stock market often commands more media attention, the bond market is actually much bigger and is vital to the ongoing operation of the public and private sector:



The world wide numbers are similar, the bond market is about twice as big.

[hodedofome]

And the currency markets trounce even the bond markets. But almost all the media focuses solely on the stock market. It's the equivalent of all the airtime being spent on high school football games while the NCAA and NFL plays in the background.

[rmendpara]

I have another hypothesis. Lets assume that the number of people who want to buy stocks is much more than the number of people who want to buy bonds.

Although the stock market often commands more media attention, the bond market is actually much bigger and is vital to the ongoing operation of the public and private sector:



The world wide numbers are similar, the bond market is about twice as big.

Absolutely correct!

Bond market is many multiples larger, but equities are far more accessible to individual (retail) investors directly.

Bonds still have to be purchased generally near par ($1k), whereas most stocks are all over. Plus, bonds are measured on credit quality, duration, and rate sensitivities rather than the name itself.

AAPL stock vs MSFT stock is a very different comparison than AAPL bonds vs MSFT bonds. Assuming they are rated similarly, the bonds will be much closer in yield for similar maturity whereas the stock could be anywhere.

The most easily understandable example of a bond is a mortgage. The bank holds a "bond" from you, and has some recourse in the form of taking the property if you fail to meet the requirements.

[humblefi]

The world wide numbers are similar, the bond market is about twice as big.

Awesome...I did not know this. Thanks.

[humblefi]

Bond market is many multiples larger, but equities are far more accessible to individual (retail) investors directly.

Bonds still have to be purchased generally near par ($1k), whereas most stocks are all over. Plus, bonds are measured on credit quality, duration, and rate sensitivities rather than the name itself.
....

Nice observation. Thanks!

[goodrookie]

You guys answered my question. I am impressed!

[astvilla]

Slight deviation from the topic but what is the theory as to why bonds and stock index funds move in generally opposite directions? Are people running to safer investments during the day when stocks drop, and running to stocks when stocks go up feeling bullish on stock?

[hodedofome]

Slight deviation from the topic but what is the theory as to why bonds and stock index funds move in generally opposite directions? Are people running to safer investments during the day when stocks drop, and running to stocks when stocks go up feeling bullish on stock?

Correlations come and go. While generally the stock and bond markets have been uncorrelated, there are plenty of times where they have moved in seemingly lockstep. But I would expect that when they are moving in opposite directions, it's because when stocks are falling people move to bonds for safety.

[KingCoin]

Another factor at play: in times of economic distress, interest rates generally fall. This will usually buoy bond prices more than widening credit spreads will hurt (at least for investment grade bonds).

[RapmasterD]

Please define "safer."

For me, a large portfolio of stocks are safer in getting us to our senior years goals. I still invest in bonds for ballast.