Stocks and Bonds, and Why the Difference Decides Everything

Owning against lending

A share is a residual claim and a bond is a contractual claim. The company pays its suppliers, its staff, its lenders and the tax authority, and whatever is left belongs to the shareholders, with no promise that anything will be. The bondholder is promised a stated coupon on stated dates and the principal back at maturity, and nothing beyond it. Everything below follows from those two sentences.

Two consequences arrive immediately. A dividend is discretionary, decided by the board each period, so cutting it is unpopular rather than unlawful; a coupon is owed on a date, and missing it is a default that triggers the lender’s rights. And because shareholders carry the risk nobody else will, they get the vote. Bondholders have no say in how the business is run, until a covenant is breached, at which point they have a great deal of say.

The same year, seen from both seats

Take a business with £100m of EBITDA, £400m of net debt at a 6% coupon, and an enterprise value of 8.0x EBITDA, so £800m. Equity value is £400m. Interest is £24m, so interest cover is 4.2 times.

EBITDA rises 15% to £115m and the multiple holds. Enterprise value is £920m, the debt has not moved, and equity value is £520m. The shareholder is up 30% on a 15% improvement in the business, because debt is half the enterprise value and the whole of the gain accrues to the half that is equity. The bondholder receives £24m, exactly as before.

Run it the other way. EBITDA falls 15% to £85m, enterprise value is £680m, and equity value is £280m, so the shareholder is down 30%. The bondholder still receives £24m. Cover has fallen to 3.5 times, which the credit market will notice and price, but the claim itself is intact.

That is the relationship in one line. The equity takes the first loss and the last gain; the debt is indifferent to both until the business is worth less than the debt. Below that point the equity has nothing left to lose and every further pound is the lender’s.

When the business is worth less than the debt

In good times the ranking 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.

A company is wound up and realises £500m. It owes £300m of senior secured debt and £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 also shows why the security in the middle of the queue is the interesting one. The senior debt is 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.

Where the two claims show up in a valuation, and who is asking

Enterprise value is the operating business before deciding who owns it, and equity value is the shareholders’ slice of it. The bridge between them is the debt: enterprise value equals equity value plus net debt, plus preferred stock and non-controlling interests where they exist.

That is why multiples pair the way they do. EV/EBITDA puts an enterprise numerator over a pre-interest figure, because EBITDA belongs to lenders and shareholders together. Price to earnings puts an equity numerator over net income, which is after interest and belongs to shareholders alone. Mixing the two is the commonest mechanical error in an interview, and it is the same mistake as forgetting who owns what.

The queue also sets the discount rate and the metrics each side watches. Equity ranks last, so equity investors demand more than lenders, and the weighted average cost of capital blends the two at market weights with the cost of debt taken after tax. The equity case is then argued in multiples and growth; the credit case in leverage, interest cover and the credit spread over the risk-free rate.

Four people read the same accounts and ask different questions of them, and saying which seat a question comes from is worth more in an interview than any definition.

• The banker advises on which claim to sell and when, and the pitch underneath both equity and debt capital markets is a recommendation about capital structure.
• The equity investor underwrites the upside: what this could become, what multiple the market would pay for it then, and whether being roughly right is enough at today’s price.
• The credit investor underwrites the downside: not how good it can get, but how bad it can get before the loan is not repaid. That is why credit work lives in cover ratios, covenant headroom, maturity walls and recovery.
• The sponsor holds both sides deliberately, buying the equity and funding it with debt raised against the target, so the return is the gap between what the business earns and what the debt costs.

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%.

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. 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 candidates get wrong

• Treating "bond" as a synonym for safe. Safety comes from the issuer and from maturity, not from the label. A high-yield bond from a struggling borrower can be riskier than equity in a stable business, and a thirty-year government bond with no credit risk at all can lose a quarter of its value when rates rise.
• Confusing the coupon with the yield. The coupon is fixed at issue and never changes. The yield is what the current price implies you will earn from here, and the two only match when the bond trades at par.
• Concluding that because debt is cheaper a company should use as much as possible. Leverage raises the cost of equity as it goes, because the shareholders’ claim becomes more volatile, and past a point it raises the cost of debt too. The cheapness is real and it is bought with fragility.

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 rates are cut. That is a tendency rather than a law, and in 2022 inflation forced rapid rate rises which hurt bonds through duration and equities through the discount rate at the same time.

The durable point survives the exception and is the one to give if you are asked. Bonds pay you first and pay you less. Equities pay you last and pay you more when there is more to pay.