Any novice investor has likely heard the terms “stocks and bonds” and “debt and equity” thrown around in pairs. As a result, it can be easy to assume that they are all terms for basically the same thing. But are they? Is a bond considered debt or equity?

A bond is a debt instrument. A bondholder lends his or her money to an entity for a specified time period, receiving periodic interest payments for use of the funds.

At the end of the agreed-upon time period, the bond issuer returns the face value of the bond to the lender, and the relationship ceases. For a more detailed analysis, keep reading to find out the key points of bonds and how they relate to debt and equity!

Is a Bond a Debt or Equity?

A bond is a debt instrument. 

As such, those holding bonds have no ownership stake in the issuing entity. 

When an entity (corporation, government, municipality, etc.) issues a bond, it is agreeing to use the lender’s money–to be repaid in full at a later date–in exchange for periodic interest payments.

There are two main components of a bond:

  • Coupon rate – the interest rate paid by the bond. This is generally locked in once the bond is issued, with interest payments commonly paid to the bondholder twice a year
  • Face value – this is the amount the bond is worth when it is issued. Sometimes called the par value, this is the debt to be repaid when the bond matures

Therefore, if a city’s utility company issued a 10-year, $1,000 bond at a 4% coupon rate, it would pay the bondholder $40 in interest each year for the use of these funds. It may issue a $20 payment twice a year or a $10 payment quarterly. It really depends on how the bond is set up.

At the end of 10 years, the city utility company would then return the $1,000 to the bondholder, and the relationship is thus complete. 

Is Debt Preferred Over Equity?

To fully answer this question, it is important to look at the debt vs. equity argument from both the issuer’s and holder’s perspectives.

Debt vs Equity: An Issuer’s Perspective

As a general rule of thumb, companies want to try and limit their exposure to debt. Debt creates a non-negotiable line item on the balance sheet. It is an expense that must be repaid. Taking on too much debt can lead to insolvency.

The positive aspect of issuing debt is that a company retains its full ownership stake. Bondholders are simply lenders whose only entitlement is the face value of the bond.

Therefore, it is generally preferable for companies to issue equity over debt. With equity financing, there is no obligation to repay shareholders in the event of insolvency. Those who buy stock do so at the risk of knowing that their investment may disappear.

With that said, issuing equity isn’t a foolproof way of raising money. Each share of stock sold is a small ownership share of the company ceded. In the event that a large enough share of stock gets concentrated in a single entity, the issuer may lose control of the company.

In addition, poorly performing stock will hurt a company’s valuation, which can lead to a whole litany of financial issues that can eventually undermine the health of the company. 

Debt vs Equity: An Investor’s Perspective

If you’re reading this blog, you are probably more interested in debt vs. equity from an investor’s perspective.

As such, the debate really comes down to a few key points of consideration:

  • What is your risk tolerance? 
  • What are your financial goals?
  • What is your investment timeline?

Bonds are the better choice for investors who have little taste for risk. With a bond, you are guaranteed a rate of return that will be paid out at predictable times. There is very little chance that you won’t get what you bargained for with a bond.

With this in mind, bonds are recommended for people nearing retirement age who have a nice nest egg and need to use that nest egg to return a stable rate of return.

Equity is better for those who aren’t intimidated by risk and need to see more sizable returns on their investment. While it is typically difficult to find investment-grade bonds that yield more than a 5% yield, a diversified basket of stocks has historically yielded average returns of around 8% a year with the potential for much more.

Therefore, equity is generally recommended for younger investors with smaller nest eggs who need to be more aggressive in growing their funds and have the time to withstand some market fluctuations. 

Is Equity Riskier Than Debt?

As you have probably gathered, equity is riskier than debt. In the event that a company goes bankrupt, it has to pay back its lenders (bondholders) first. Every avenue for repaying lenders must be exhausted before an entity can default on its loans/bonds.

The entity is under no obligation to repay stockholders in the event of insolvency. They may buy back shares at a deep discount if any funds remain after all other obligations are met, but there is no guarantee that this will happen.

Is There Any Risk With Debt?

Although bonds are less risky than stocks, they are not completely risk-free.

In the event that a corporation, municipality, or government were to completely collapse, there is a chance you might not retrieve the face value of your bond. While this is highly unlikely, it is not unprecedented.

The most significant risk with bonds is known as “interest rate risk.” This occurs when you purchase a bond at a given coupon rate, only to see interest rates skyrocket. 

If you get a bond at a 3% coupon rate and then the interest rates jump to 5%, you are essentially locked into a yield that is getting outstripped by inflation. This hurts the value of the bond on the secondary market (a way that bonds trade like stocks, which is outside the scope of this article). This is actually happening in the bond market right now amid the historic battle against inflation in the United States. 

There are also bonds known as “junk bonds” that are quite risky. For a higher coupon rate, you can buy bonds in companies that have a high chance of going bankrupt. This is less risky than holding stock in these companies but definitely riskier than purchasing investment-grade bonds. 

Is a Bond Debt or Equity? The Bottom Line

A bond is a debt instrument. A bondholder loans funds to the issuing party for a specified time in exchange for periodic interest payments. This is a less risky form of investment than stocks (equity), in which small ownership stakes of a company are purchased in exchange for all accompanying appreciation or depreciation in the company’s value. 

We hope you found this useful!

Geek, out.

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