Bonds offer lower returns on your investment for one simple reason: They are considered safer. Bonds have a regular schedule of fixed payments, so you know exactly how much money you will be paid and when. The risk is the creditworthiness of the entity issuing the bond. Stocks, however, pay irregular dividends with face values that vary wildly. As such, investors in stock are compensated for their additional risk with higher returns.
Debt vs. Ownership
The reason that stocks and bonds act differently is because they are two completely different assets. To own stock means to have ownership in something: A stock share is a literally a “share” in a company, entitling the holder to dividends (when paid) and, generally, voting rights. The rewards on ownership can be high, but so are the risks. If the company goes out of business, the stock becomes worthless. A bond is what is called a debt instrument. It is literally a loan an investor makes to an entity like a city or a corporation. It is a contract that stipulates, when issued, a face amount, how much interest it will pay and when, and when the investor will get all his money back. If an entity goes bankrupt and cannot repay the loan, its assets are generally liquidated to raise cash, and the debt holders are paid back before the shareholders.
A Matter of Rating
Of course, not all bonds are created equal. Bonds are rated by agencies on their creditworthiness by factors like cash flow, cash on hand, collateral and outstanding debt -- the same factors the bank checks out when making a loan to an individual. Moody’s, one of the three main rating agencies, rates bond in descending order of creditworthiness: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. The higher the rating, the lower rate the issuer pays to the investor, and the lower the returns, because the risk is lower. Anything below Baa is considered a “high yield” or “junk” bond; below a C rating the issuer is in default -- it has stopped paying.
High-yield bonds offer higher returns to compensate for higher risk involved because of a lower credit rating. Other types of bonds are created out of many loans -- on cars or homes, for example -- “wrapped” together. These are called collateralized debt obligations, and while they act like bonds, with scheduled payments and return of principal, they are much riskier, which can result in higher returns.
Risk vs. Reward
In short, bonds produce lower returns for investors because they are safer than investing in stocks. But that is not to say that bonds are without risk. To get higher returns on bonds -- sometimes better than in the stock market -- invest in high-yield bonds, but be prepared to deal with greater risk.
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