How do stocks and bonds work? (2024)

Stocks and bonds have always been important types of investments. In fact, together with cash, they represent the foundation of most investors’ portfolios. Our goal here is to help you understand the differences between these two investment vehicles so you can make the right decisions based on your goals, time horizon and risk tolerance.

When you own a stock, you own a part of a company. You become a shareholder. Both private and public companies issue stock to generate capital that they can then reinvest in its operations. For the sake of simplicity, we won’t be discussing private companies as the vast majority of trading and investing involves stocks of public companies.

If stock represented the company’s current value and nothing more, it would be a lot easier to calculate its value. But a stock’s price today also includes projections of it’s performance into the future. There are teams of analysts whose livelihoods depend on predicting future stock value. Speculation of this kind has a significant influence on a stock’s trading price.

Stocks are purchased and sold through a network of brokers, like Scotia iTRADE, on the stock market. Public companies who issue stocks are regulated and must adhere to strict financial requirements which include, but are not limited to, issuing reports and other forms of financial updates.

You buy and sell stocks on stock exchanges (or stock markets), the top of which include the Toronto Stock Exchange (TSX) in Canada, and the New York Stock Exchange (NYSE) and NASDAQ in the United States.

A company’s market capitalization, or market cap, is the total value of all of the company's shares. The calculation is simple: multiply the stock’s price at any given moment by the total number of outstanding shares. For example, a company with 10 million outstanding shares selling at $25 a share would have a market cap of $250 million.

If you’re an owner of common stock, you receive a share of the company’s annual profits, but only after bondholders receive their interest payments and holders of preferred stock receive their payments. As a common shareholder, you may also have the right to vote in elections that impact the company's board of directors.

Shareholders of preferred stock have a higher claim on any of the company’s profits than do common stockholders.Preferred stock typically does not grant shareholders voting rights.

There is a long list of factors that traders and investors should consider before buying stock:

• Market price
  This is the stock market's appraisal of the worth of a company’s stock at a specific moment in time. You may find this price constantly changing throughout the day, sometimes in very small increments. The things that may impact market price include, but are not limited to, changing business conditions and investor/trader emotions.
• Price-to-earnings ratio (P/E ratio)
  When you divide a stock’s price by the company's earnings per share you end up with its P/E ratio. Also referred to as the “P/E multiple”, the P/E ratio approximates how much an investor is willing to pay for one dollar of earnings. The ratio can also be calculated by using an analyst's projection of expected future earnings.
• Dividend yield
  The dividend yield shows you what percentage return the company is paying its investors from dividends It’s calculated by dividing the amount of the dividend by the share price. High dividend yields may seem attractive but they’re not guaranteed. Although relatively rare, companies can cancel or downgrade dividend payments.
• Payout ratio
  This percentage represents the earnings a company is paying out to its investors instead of reinvesting in itself.

A trading account with a brokerage enables you to place stock orders. These are four of the most popular types of stock orders:

Market Orders

These represent the majority of individual stocks bought and sold. When you place a market order, it means you agree to buy or sell stock at whatever the market price is at the time the exchange receives your order.

Limit orders

When you use a limit order to buy shares, you’re setting a cap on the amount you’re willing to pay per share. This price is typically set below the current ask price. Conversely, a limit order when you’re selling stock means you’re setting a floor on the lowest price per share you’re willing to accept from buyers. Typically this price is set above the bid price.

By the way, it should be mentioned that, although a price is being set, whether on the buy or sell, there is no guarantee that there will be enough available volume (that is willing buyers or sellers) at that price to partially or completely fill your order.

Stop orders

Using this type of order with Scotia iTRADE, we assume you have an existing position, whether long or short, of the underlying investment. So when you place a stop order, you’re submitting a buy or sell order, depending on

your underlying position, with a specified ‘stop price’ to exit that position. This means that, once your specified stock price is reached, your buy or sell order will be implemented on the exchange as a market order. These are typically used in risk management strategies and are only available on U.S. stock exchanges.

Stop limit orders

For Canadian stock exchanges, a stop limit order is used. Similar to a stop order, you specify a ‘stop price’ for the order to be implemented. However, if this price is breached, then the order will be implemented as a limit order instead of a market order. So stop limit orders will require you specify both a ‘limit price’ and ‘stop price’ when submitting these orders.

Bonds don’t incite the same excitement that individual stocks do, yet that doesn’t make them any less important in a portfolio. They are sources of fixed income rather than the potential higher returns of stocks. Factors such as your investment time horizon and risk tolerance can greatly influence the proportion of bonds in your portfolio.

A bond is basically a type of investment that represents a loan between a lender (you, the bond holder) and the issuer (a corporation or government). So when you buy a bond, you’re essentially loaning one of these entities money.

There are two main types of bonds:

Governments issue bonds, including municipal bonds, provincial bonds and federal bonds, such as Treasury Bills, or T-Bills. (Canadians can also buy Treasury Bonds from the U.S. government although we won’t be covering that topic here.)

Corporate bonds which tend to pay a higher interest rate than government bonds.

Note: As of November 2017, the sale of Canada Savings Bonds – an investing tradition embraced by generations of Canadians – was discontinued by the federal government

As a bond holder, a company promises to give you fixed interest payments for a specified period. When the bond matures, the interest payments stop and your initial investment is returned to you. Here’s a fictional bond scenario:

Face value (or your principal): $10,000

Annual Coupon value: 4%

Term to maturity: 3 years

Bonds will on occasion sell for more or less than their face value. This is called a premium or discount. Dividing the annual coupon payment by the bond’s price determines its yield.

Bond prices tend to follow the trajectory of interest rates. So in our current low interest rate environment, bond yields are modest. However, bonds will help diversify portfolios, and may help mitigate some of the inherent volatility of stocks.

Most bond trading happens over-the-counter (OTC), unlike stocks which are purchased on stock exchanges. That means they are purchased and sold through investment advisors from inventories managed by brokerage firms in

the OTC market. Newly issued bonds are sold on the primary market, while previously issued bonds are traded in the secondary market.

You can also get exposure to bonds indirectly through bond mutual funds, index funds and exchange-traded funds (ETFs).

Terms of maturity and credit risk are the two key factors to consider when purchasing bonds.

Credit risk (or default risk) measures the potential of a bond issuer to default on payments of interest and principal. While corporate bonds pay higher coupons than bonds issued by governments, investors take on higher risk. When researching options, investors should consult credit rating agencies such as DBRS Canada, or Moody's, Standard & Poor's and Fitch. These agencies work to rank bonds from investment grade to non-investment grade..

The higher risk you’re willing to take on with your bond, the more compensation you should expect. Conversely, government bonds offering lower credit risk relative to corporate bonds will likely offer lower yields than corporate bonds.

In the case of maturity dates, the longer you have your money tied into a bond, the more interest you should expect on the loan. A case in point: a 15-year bond should offer a higher coupon than a 5-year bond, all else the same, however, be aware that longer term bonds will be subjective to more interest rate risk than shorter term bonds. Terms of maturity can range from short term (less than a year) to long term (30 years).

Up until now, we’ve talked about stocks and bonds individually. Let’s take a few moments to highlight the practical differences between the two.

Ownership versus creditorship

As a shareholder of a stock, you are a partial owner of a company, and may have voting rights based on the kind of stock you own. With bonds, you are simply a creditor of a company and have no voting rights nor ownership.

Value and price fluctuations

Stock prices are in constant flux as a result of factors such as supply and demand, earnings per share, price-earnings ratio, as well as a host of economic catalysts. On the other hand, bond prices fluctuate primarily on interest rates.

Risk and reward

Generally speaking, stocks carry more risk than bonds. While a stocks’ growth potential is considered superior to bonds, stock prices can fluctuate dramatically as a result of a wide range of factors. By comparison, bonds are fixed income instruments, so you receive your investment back at maturity with the interest agreed upon, assuming the borrower remains solvent.

Where and how they’re traded

Stocks are bought and sold on stock exchanges while bonds can only be traded on over-the-counter (OTC) markets through brokers or other authorized professionals and institutions.

Taxation

Income from your investments can come in a number of different forms, including interest, dividends and capital gains. Each one is treated differently from a taxation perspective.

Before we dig into the details, it’s important to note that income generated from stocks may be treated differently by the Canadian Revenue Agency (CRA) depending on whether you are a day trader or an investor. What’s the distinction? It really comes down to your intent when buying and selling stock.

If you’re a day trader – someone who buys stocks with the intention of selling them quickly – any gains you realize will be treated as business income. In other words, to the CRA, day trading is a job like any other.

If you’re an investor – a person who buys stocks with the intention of holding onto them for the long-term – any resulting income will be treated as capital.

With that out of the way, let’s look closer at the different investment income and the tax ramifications of each:

• Dividends paid by eligible Canadian corporations receive favourable tax treatment under the federal dividend tax credit.
• Capital gains is considered a taxable income but also receives favourable treatment. Only half of capital gains is subject to tax.
• Interest income from bonds, GICs, T-bills and the like is taxed at your marginal tax rate, with no preferential tax treatment given
• Dividends from foreign corporations don’t benefit from the federal dividend tax credit, and are fully taxable, like interest income.

What about income that is generated from your job or interest in, say, a savings deposit account? These income types are taxed at your highest marginal tax rate, so they’re not as tax efficient as dividends and capital gains.

Stocks - The Pros

• The potential for higher returns than bonds over the long term
• Some stocks pay dividends, which can cushion a drop in share price, provide extra income or be used to buy more shares
• Typically good liquidity
• Only 50% of the value of any capital gains are taxable if you are an investor, not a day trader

Stocks - The Cons

• Price fluctuations are constant and sometimes dramatic
• Investors do not receive a guaranteed return, potentially experiencing a loss of value on their investment

Bonds – The Pros

• Bond prices tend to be less volatile than stocks
• The potential for better income stability
• Typically good liquidity

Bonds – The Cons

• Historically, bonds have generated lower long-term returns than stocks
• If interest rates go up, bond prices tend to fall

Every type of investment has its own unique attributes. Stocks and bonds are no different. Stocks offer investors higher potential long-term returns but with greater risk. Bonds are more stable but offer lower long-term returns.

. The combination of these two investment types, together with cash, can be leveraged to optimize asset allocation. The right asset allocation strategy will be based on your age, financial goals, investing time horizon and risk tolerance. For instance, as you age, you may be more risk averse which would likely lead to a higher portion of fixed income investment vehicles – such as bonds – within your portfolio.

So getting back to the question, Which one is right for you? Very likely you’ll need both stocks and bonds in your portfolio. The specific mix of the two will differ, however, from one investor to another.

Ready to start buying and selling stocks and bonds? Scotia iTRADE enables you to get real-time quotes, hundreds of detailed analyst research reports covering stocks in all major sectors, detailed fundamental and technical analysis, and the option to search by symbol or company name.

Plus, if you’re investing in bonds, you’ll enjoy simplified, transparent pricing with no markups or hidden fees. You’ll find a large inventory of fixed income products, including Canadian and U.S. bonds, corporate bonds, strip bonds, T-bills, high-yield bonds and more. Log on to your account, oropen an account here.