Table of Contents
- Bonds vs Stocks: Which Is Better When Rates Are High?
- Stocks vs Bonds: Key Differences
- Protection From Price Swings
- Bottom Line
- Frequently Asked Questions (FAQs)
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The past few years have shown that all investments, no matter the type, are subject to market fluctuation and can never guarantee endless cycles of growth.
Whether its property, cryptocurrency, the stock market or bonds, investors have faced periods of intense volatility, prompted by the Covid-19 pandemic and, more recently, by rising interest rates.
While there are many types of investments, stocks and bonds are two of the more popular options for Australian investors and both have been affected by inflationary pressures, according to Jordan Miyakawa, Head of Research at IMC Trading.
In fact, in the first half of 2022, the ASX200 declined by 17%, Miyakawa says, before returning to trade within a whisker of its highs earlier this year on premature hopes of an end to the rate hiking cycle.
“Bonds weren’t immune to inflation-driven interest rate reset either,” Miyakawa tells Forbes Advisor.
“For example, the yield on Australia’s 10-year government bond rose 3.5% between 2021 and 2022. Given that the price of most bonds are inversely related to interest rates, many posted negative returns during this period, with their coupon payments insufficient to offset the drop in their prices.”
As a result, many Australian investors are weighing up whether bonds or stocks are the best choice of investment in the current climate. As with all investments, the answer remains subjective: there are both pros and cons to investing in both asset classes.
Bonds vs Stocks: Which Is Better When Rates Are High?
“Generally speaking, bonds as an asset class are less risky than stocks,” Miyakawa says. Meanwhile, stocks provide higher returns, but with higher volatility.
“However, high inflation and its impact on interest rates have made answering this question [of which is better to invest in] more complex.”
In this environment of high interest rates, Miyakawa says it’s important to focus on “their direction”.
“That’s because if economic activity holds up when interest rates rise, stocks will continue to provide higher returns along with higher volatility.
“On the other hand, if inflation and interest rates decline alongside a more serious economic downturn or even a recession, bonds are the safer investment.”
Stocks vs Bonds: Key Differences
Let’s explore the key differences between stocks and bonds.
Stocks
Purchasing stocks is the process of purchasing a piece of the company. The more stocks you buy in a company, the more of the company you own; that’s where the term ‘shares’ comes from, as you are purchasing a share in the publicly listed company.
The general public can purchase shares via the stock market, with different exchanges available in different countries. In Australia, this is the Australian Securities Exchange (ASX). Australian companies that are publicly traded are listed on the ASX for investors to purchase or sell shares.
If the company performs well, the value of the company’s shares will increase. If you sold these shares after the value increased, you would turn a profit. Of course, the inverse is also true: if the company performs poorly, the value of shares will decrease. In this case, you would lose money.
Since the share market is constantly moving while trading is open, the value of shares is constantly fluctuating. This constant movement makes investing in shares a difficult process, as investors can see large amounts of growth or losses in a matter of minutes.
It is often advised that people do not buy into these quick changes in value, and rather hold stocks over a period of time in companies that have a history of demonstrated growth. However, past performance is not an indicator of future performance.
Bonds
On the other hand, bonds are considered a safer asset to invest in as they offer a fixed rate of return rather than a fluctuation in value. The disadvantage is that they also do not reach the highs in values that stocks experience when companies are performing well. In periods of high inflation, it may mean that your fixed rate of return is lower than the CPI.
When investing in bonds, you are lending money in return for regular payments (known as coupon interest payments). Rather than buying a part of the company like you do with shares, bonds involve you, the investor, lending the company, or the government, money.
You are then paid interest for a set period of time and, once the bond matures, you will be paid back the full amount you purchased the bond for. If a company defaults during this period, however, you’ll stop receiving payments and won’t be paid back for your initial investment.
As the Australian Government has never defaulted on the interest or repayment of the principal payments on the bonds, government bonds are considered particularly safe. Corporate bonds, however, are more similar to the risk profile of shares and ASIC warns consumers to be wary of corporate bond offers that seem too good to be true.
Protection From Price Swings
Ultimately, high-quality bonds–in particular government bonds–should deliver solid returns on safe-haven demand during times of economic turbulence, Miyakawa says, even outperforming stocks. That’s because stocks can come under pressure from the impact of earnings and they fluctuate much more dramatically even over short periods of time.
“With interest rates already at high levels, there are now a lot of high-quality bonds available in the market offering attractive interest rates,” Miyakawa explains.
“Certain government and investment-grade corporate bonds can deliver strong returns with lower risk than stocks. Holding these bonds until maturity can ensure you collect these interest and principal payments without being exposed to temporary price swings as interest rates move around, assuming the bond issuer doesn’t default, of course.”
The key point to note is holding the bonds until maturity to ride out any turbulence in the market.
Miyakawa also points out that the type of bond plays a key role in its performance, as “riskier corporate bonds perform similarly to stocks, delivering negative returns with high volatility”.
Bottom Line
Australia’s economy has held up fairly well when considering the cumulative 4% of RBA hikes in little over a year, Miyakawa says.
This resilience, and the perception that rates are near or at the peak both at home and abroad, have allowed stocks to stage an impressive recovery. Bond prices, meanwhile, have remained sluggish as rates stay elevated.
“Although the soft-landing scenario could easily continue to play out and boost the stock market further, there remains uncertainty over the economic outlook. We know that the economy is impacted by interest rates with a lag and there are spots of weakness showing, Miyakawa says.
“If there is a more serious economic downturn, stocks could have a fair way to fall.”
While there seems to be a better asymmetric payoff with bonds, it is still essential for investors to do their due-diligence to minimise default risk.
Ultimately, Miyakawa says, whether bonds or stocks are the better investment when inflation and interest rates ease, depends largely on one’s risk tolerance and their expectation for economic growth.
When investing, it’s possible to lose some, and very occasionally all, of your money. Past performance is no prediction of future performance and this article is not intended as a recommendation of any particular asset class, investment strategy or product.
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Frequently Asked Questions (FAQs)
Do bonds or stocks have better returns?
Typically, stocks tend to perform better than bonds in terms of offering higher returns. With that reward, however, comes higher risk. Stocks are more volatile than bonds, so investors may risk losing some or all of their investment–or even find themselves at a loss.
Bonds, meanwhile, are seen as a more safe-haven investment, as holding a bond until maturity will usually see a payout higher than your initial investment, thanks to regular coupon payments and the return of your initial investment, as long as the bond does not default.
Which is riskier: bonds or stocks?
Stocks are seen as more of a risky investment due to their volatility. When investing in stocks, there is no guarantee that you will turn a profit upon selling the stocks; in fact, you could lose your initial investment and then some. Stocks are tied to a company’s performance and can fluctuate in a matter of minutes when the stock market is open for trading.
This constant change can result in investors buying and selling stocks frequently, trying to make a profit. Bonds, on the other hand, are best held until they reach maturity, and are seen as a much safer investment due to less volatility.
Should I buy bonds or stocks right now?
As with all investments, there is no one size fits all. Whether or not you should invest in bonds or stocks at any given time depends entirely on your risk appetite and expectation for growth. If you want to run the gauntlet of achieving high returns, stocks are your best chance at doing so–yet they also come with the risk of losses. If you would prefer to receive regular repayments and the return of your initial investment eventually, then investing in a bond may be more suitable for your portfolio.
Regardless of the type of investment you purchase, turning a profit is never guaranteed.
Bonds vs Stocks: Which Is Better When Rates Are High?
According to Jordan Miyakawa, Head of Research at IMC Trading, both stocks and bonds have been affected by inflationary pressures in recent years. The ASX200, for example, declined by 17% in the first half of 2022 before recovering to trade near its highs. Bonds also faced challenges due to rising interest rates, with the yield on Australia's 10-year government bond rising 3.5% between 2021 and 2022. Many bonds posted negative returns during this period as their prices dropped [[1]].
Generally speaking, bonds are considered less risky than stocks, while stocks provide higher returns but with higher volatility. However, answering the question of which is better to invest in during high interest rates is more complex. Miyakawa suggests that the direction of interest rates is crucial. If economic activity remains strong as interest rates rise, stocks may continue to provide higher returns. On the other hand, if inflation and interest rates decline alongside a serious economic downturn or recession, bonds are considered the safer investment [[1]].
Stocks vs Bonds: Key Differences
Stocks: When you purchase stocks, you are buying a piece of the company. The more stocks you own, the larger your share in the company. Stocks are traded on stock markets, such as the Australian Securities Exchange (ASX). If the company performs well, the value of its shares increases, allowing you to make a profit when selling. Conversely, if the company performs poorly, the value of shares decreases, resulting in a loss. Investing in stocks can be challenging due to their constant fluctuation in value, which can change rapidly during trading hours. It is generally advised to hold stocks over a period of time in companies with a history of demonstrated growth [[2]].
Bonds: Bonds are considered a safer investment compared to stocks because they offer a fixed rate of return. When you invest in bonds, you are lending money to a company or government entity. In return, you receive regular coupon interest payments for a set period of time. Once the bond matures, you are repaid the full amount you initially invested. However, if the bond issuer defaults, you may not receive payments or the return of your investment. Government bonds are generally considered safer than corporate bonds, as the Australian Government has never defaulted on interest or principal payments. Corporate bonds carry a similar risk profile to stocks, and consumers are advised to be cautious of corporate bond offers that seem too good to be true [[2]].
Protection From Price Swings
During times of economic turbulence, high-quality bonds, particularly government bonds, are expected to deliver solid returns due to safe-haven demand. They can even outperform stocks, which are more susceptible to earnings impact and dramatic fluctuations. Holding bonds until maturity can help mitigate temporary price swings caused by changing interest rates, assuming the bond issuer does not default. Miyakawa emphasizes the importance of riding out market turbulence by holding bonds until maturity [[1]].
Bottom Line
Australia's economy has shown resilience despite interest rate hikes, allowing stocks to recover impressively. However, there is still uncertainty regarding the economic outlook. If a more serious economic downturn occurs, stocks could experience significant declines. Bonds, particularly high-quality government bonds, can provide attractive interest rates and lower risk compared to stocks. Ultimately, the choice between bonds and stocks depends on an individual's risk tolerance and expectation for economic growth. It is important to note that investing always carries the risk of losing some or all of your money, and past performance is not indicative of future results [[1]].
Frequently Asked Questions (FAQs)
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Do bonds or stocks have better returns? Typically, stocks tend to offer higher returns than bonds. However, stocks also come with higher risk and volatility. Bonds are considered a safer investment, as holding them until maturity usually results in a payout higher than the initial investment, thanks to regular coupon payments and the return of the initial investment, as long as the bond does not default [[3]].
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Which is riskier: bonds or stocks? Stocks are generally seen as riskier due to their volatility. The value of stocks can fluctuate rapidly, and there is no guarantee of making a profit when selling them. On the other hand, bonds are considered safer and less volatile. It is advisable to hold bonds until maturity to minimize risk [[3]].
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Should I buy bonds or stocks right now? The decision to invest in bonds or stocks depends on your risk appetite and growth expectations. Stocks offer the potential for high returns but also come with the risk of losses. Bonds provide regular repayments and the return of the initial investment over time. However, there is no guarantee of turning a profit in either case. It is essential to consider your individual circumstances and do thorough research before making any investment decisions [[3]].
Remember, investing involves risks, and it is always recommended to consult with a financial advisor or do thorough research before making investment decisions.