Stocks and Bonds, and Why the Difference Decides Everything

Owning against lending

A share is a residual claim. The company pays its suppliers, its staff, its lenders and the tax authority, and whatever is left belongs to the shareholders. There is no promise attached to it. If there is nothing left, shareholders receive nothing and have no recourse, and if the business does extraordinarily well, the whole of that upside belongs to them.

A bond is a contractual claim. The issuer agrees to pay a stated coupon on stated dates and to return the principal at maturity. That is the entire deal, and it caps the return: if the company triples in value, the bondholder still receives the coupon. What the lender gets in exchange for giving up the upside is a promise that ranks ahead of the owners and that can be enforced.

The queue, which is where the difference becomes real

In good times the distinction is theoretical. In a liquidation it is everything, because the assets are distributed in a strict order and each layer is paid in full before the next receives anything.

Work one through. A company is wound up and realises £500m. It owes £300m of senior secured debt, £250m of unsecured bonds, and has shareholders. Senior secured takes its £300m in full. The remaining £200m goes to the unsecured bonds, which recover £200m against £250m owed, so 80 pence in the pound. Equity receives nothing, and would have received nothing if the recovery had been £549m too.

That example also shows why the security in the middle of the queue is the interesting one. The senior debt is going to be repaid whatever happens and the equity is worthless in every case; the unsecured bond is the claim whose value actually depends on what the business is worth, which is why a restructuring negotiation is usually a fight between the holders of that layer and everybody else.

This is also the intuition behind a company’s cost of capital. Equity sits last in the queue, so equity investors demand a higher return than lenders. A firm whose cost of equity is lower than its cost of debt has almost certainly made an arithmetic error.

How each one is priced

A bond has a defined set of future payments, so pricing it is a discounting exercise with one unknown: what rate the market demands for that risk. The yield is the rate that makes the present value of the coupons and principal equal the price. Because the payments are fixed, price and yield move in opposite directions by construction. If market rates rise and a bond still pays its old coupon, the only way to make it competitive is for its price to fall.

How far it falls is duration, which measures sensitivity to rates. A bond with a duration of seven loses roughly 7% of its value for a one percentage point rise in yields. Long-dated bonds have higher duration than short-dated ones, which is why a portfolio of thirty-year government bonds can behave nothing like a portfolio of two-year ones even though both are described as safe.

A share has no defined payments, so valuing it means forecasting the cash the business will generate and deciding what that stream is worth. That is a discounted cash flow. The shortcut version applies a multiple to a current earnings figure and lets the multiple carry the assumptions about growth and risk, which is faster and is what a comparable companies analysis does.

The practical consequence is that a bond can be valued precisely and be wrong about credit risk, while a share can only be valued approximately and the range is the honest answer. Interviewers ask about this because candidates who have only ever built a DCF tend to treat its output as a number rather than as a range.

Why a company issues one rather than the other

Debt is cheaper, for two reasons. The lender takes less risk and so demands less return, and the interest is deductible against tax, so a business paying a 6% coupon at a 25% tax rate bears an after-tax cost of 4.5%. That deduction is the depreciation tax shield’s cousin and it is a real transfer of value from the state to the borrower.

Debt also does not dilute. Issuing shares to fund an acquisition hands part of every future pound of profit to new owners; issuing bonds does not, and the existing shareholders keep whatever the money earns above the interest cost. This is the entire mechanism behind a leveraged buyout.

The limit is that the promise is enforceable. Equity can have its dividend cut in a bad year and the company carries on. A missed coupon is a default, with the covenants, the acceleration rights and in the worst case the insolvency process that follow. So the capital structure question is always a trade between the cheapness of debt and the fragility it introduces, and the right answer depends on how predictable the cash flows are. A regulated utility can carry leverage that would destroy a fashion retailer.

What it means for a portfolio

The traditional case for holding both is that they tend not to fall together. Equities do well when growth is strong; government bonds do well when growth disappoints and central banks cut rates. Holding both was supposed to mean one leg cushions the other, which is the reasoning behind the familiar sixty forty allocation.

That relationship is a tendency rather than a law, and 2022 is the reminder. Inflation forced rapid rate rises, which hurt bonds through duration and hurt equities through the discount rate at the same time, and both fell hard together. A generation of portfolios was built on a correlation that had held for two decades and did not hold that year.

The durable point underneath it is simpler and survives the exception. Bonds pay you first and pay you less. Equities pay you last and pay you more when there is more to pay. Which you want depends on when you need the money and how much of a fall you can tolerate on the way, and that is a question about the investor rather than about the securities.