Stocks and Bonds Explained

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You have likely heard that stocks and bonds are your keys to financial success. But you may not have any idea what they actually are and why they are so well-regarded. Here is a brief explanation of stocks and bonds: a definition of each, different types of each and the uses for each.

Definition of Stock

  • A stock is a type of security that represents a share of ownership in a firm. Stock owners share proportionally in the profits, losses and the speculative demand for a firm's business, according to the percentage of the firm they own. If a firm earns a substantial amount of revenue over a particular period, the firm's management may choose to distribute a portion of the firm's profits in special quarterly payments called dividends. Or the firm's stock price may increase based on the market's appetite for the well-performing firm. By contrast, if the firm earns less than expected or no revenue over a period, its price will likely decrease, as market demand for the stock decreases.

Types of Stock

  • There are two types of stock: common and preferred shares. Common stock proffers holders the right to vote on certain types of corporate decisions. Preferred stock, while not entitling owners voting rights, does entitle owners to a set rate of dividends, which must be paid before the dividends on common stock can be paid. Preferred stockholders are also entitled to a share of the firm's assets in the event of a bankruptcy before common stock owners.

Uses for Stock

  • Individual and professional investors purchase stock either to reap the benefits of the gains of a well-performing firm, or for speculative reasons. Investors buying stock on speculation look to profit on short-term changes in the price of a firm's stock.
    Firms issue shares to raise capital, or funds that may be used to expand the firm, invest in research and development, and/or acquire other firms, among other reasons.

Definition of Bond

  • A bond is a debt agreement entitling the lender to the return of his principal and a series of interest payments over a period of time; the end of that period is known as maturity. Corporate bonds, or bonds issued by firms, may be secured or unsecured. Secured bonds are issued with a certain asset as collateral--if the bond interest and/or principal payments are not paid by the issuing firm, the lender is entitled to the asset. Unsecured bonds do not involve the use of collateral assets; because they are riskier, they usually pay higher interest rates.
    Unlike stocks, bonds may be issued by government entities such as cities.

Types of Bonds

  • There are many different types of bonds, including, but not limited to:

    • Fixed-rate bonds, which pay a constant rate of interest to the borrower.
    • Floating-rate notes, which pay a variable interest rate to the borrower. Usually the rate is linked to an interest rate index.
    • Zero-coupon bonds, which are sold at a discount to the bond's value and return the principal upon maturity, but pay no interest.
    • Inflation-linked bonds, in which the principal and interest rate are linked to the prevailing inflation rate.
    • Asset-backed securities, which are secured by cash-generating assets.
    • Perpetual bonds, which have no maturity date, but pay interest payments in perpetuity.

Uses for Bonds

  • Individual and professional investors may buy bonds to provide a steady stream of income, or for speculative reasons. Bonds are bought and sold at either a premium or a discount based on the market's appetite for a particular bond. As such, there is the potential for price appreciation as well as the risk of principal loss.
    Firms and government entities issue bonds to raise capital for any number of activities, including facility upgrades, capital projects and acquisitions, among other initiatives.

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