July 17, 2011

Bonds are Safer than Stocks

Recently Jim at Bargaineering asked Are Bonds a Safe or Risky Investment?   He concluded "In the end, I don’t think bonds are any safer or less risky than investing in stocks."   Theres more to his discussion then that, so read his full article for all the details.    I thought this was a good topic to discuss so I'll give my take on it.

In general as classes of investment : Bonds are safer than stocks.   If you look at the two classes of investments there are several reasons why bonds are safer.

1. Protection of principal.    If you buy a bond then hold the bond to term you will get back your principal.   With a stock you have no expectation at all that your principal will be refunded.  

2. Defaults and bankruptcy are generally better for bonds than stocks.   Bond holders have a higher priority to recover funds if a company goes bankrupt.   Remember when GM went bankrupt?   The bond holders got 29% of their money back (if I recall right).   What do you think the stockholders got?  Nothing much.

3. Guaranteed returns rather than speculation on appreciation.    With bonds you have a fixed rate of return.   With stocks you hope your investment might do better and if theres dividends then you hope the company will continue to pay them.   With bonds you have a contract that says you'll get paid X interest for the term of the bond.  Theres no hoping, its an agreement.

4. Lower volatility.    Bonds can go down in value based on fluctuation in interest rates and the market forces.   So yes, bonds can lose their value.   However stocks are much more volatile.   Stocks can go down significantly in short periods of time.  In general the volatility of bonds is much lower than stocks.

Lets compare the Vanugard Total Stock Market ETF (VTI) versus their Total Bond Market ETF (BND).   For the past 5 years this is how their prices have looked, red is VTI and blue is BND (click on image for larger version):

Clearly the bond fund has been much less volatile.   Of course this is just a short few year period for two ETFs, but if you look back longer periods the markets are much more volatile for stocks.   Stocks have bigger ups and downs over time in general. 

Different risk levels for individual bonds and stocks
Of course there are different kinds of bonds and stocks out there.   Now that I've said in general that bonds are safer than stocks, I should point out for completeness that not all bonds are created alike.  There are riskier bonds and safer stocks.  A junk bond is a riskier investment than buying GE stock but US Treasuries are much safer than Enron's of the world.   However, if you buy bonds or stocks of entities with similar credit ratings then your overall risks will be higher in general with the stocks.

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