The most basic difference between stocks and bonds is when you own a share of stock, you own equity or a fractional percentage of the company. Stock prices fluctuate according to the value of the company. When you own a bond, you own debt. You are lending the company money that it must pay back at maturity, along with semiannual payments of interest. Bond prices fluctuate according to market interest rates.
A company issues stock in return for capital investment. When a private company launches, the founders raise money to fund the startup by selling private stock, often to their friends, family and angel investors. Anyone who holds stock in the company owns a portion of that company. When the company is ready to go public, the stock is registered with the Securities and Exchange Commission and is sold to public investors through a public offering. This adds more capital to the company, increasing its assets and, therefore, its value. Original shareholders in the private company often take their investment profits at this time by selling their stock.
Investing in Stock
When you buy stock that is already trading, you are not giving the company capital — you are purchasing someone else's portion of ownership in the company. If the company pays a dividend, you are also purchasing the right to receive that dividend. If the company reports good earnings and demonstrates that its future is likely to be successful, the value of the company rises and, because your stock is evidence of a percentage ownership in the company, its theoretical intrinsic value rises. Usually this is reflected in a rise in the price of the stock, but during bear markets or if other investors don't buy on the good news, your stock price may not rise. Similarly, if the company loses money and important contracts are canceled, its value declines and so does the price of its stock.
A company also can fund itself by borrowing. Privately, these borrowings can be simple promissory notes or convertible debt, which gives the lender the choice of being paid back in cash or in stock. If the lender thinks the company has promise as an investment, he will choose to be paid back in stock because he thinks the company will have a successful IPO and he will be able to sell his stock at a high price. If the company is already a public company or qualifies with the SEC to issue bonds publicly, it can borrow money in the public bond market. All bonds are evidence of debt.
Investing in Bonds
When you buy a bond, your bond certificate testifies that the company owes you payment of the face value amount, typically $1,000, on the certificate at a certain date in the future, called the maturity date. It also indicates a coupon rate, which is the amount of interest set when the bond was first issued. The coupon payment will remain the same unless there is a floating rate or repricing provision in the issue. A bond's price fluctuates according to the prevailing market interest rate for its credit rating. Bond prices will also fluctuate if the company is doing so well or so badly that its credit rating is changed. Investors lend money to a company, via bonds, and expect the coupon interest income to be attractive enough to make it worthwhile taking the risk of lending money that won't be paid back for years. As market interest rates rise, the price of the bond drops so the money received in interest represents a percentage of $1,000 equal to the market rate for that credit rating. Similarly, as the market interest rates drop, the price of the bond rises.
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