Difference between Bonds and Shares

Bonds and Shares

A question that people probably ask what is the difference between bonds and shares. If you have a little bit knowledge about bonds and shares, you may easily respond to this question! Difference between bonds and shares is that stocks are shares in the ownership, while bonds are a form of debt that’s to be repaid in future.

Difference between Bonds and Shares

To know about the difference between bonds and shares, let’s discuss both bonds and shares in detail one by one. Most companies and governments issue bonds in order to raise capital for their smooth functioning. 

Bond

A bond is a direct claim security in the form of a piece of paper that represents borrowing or long term loan. It is actually a debt instrument that is issued by a borrower (company) in favor of a lender (investor) for some fixed amount of money. The amount borrowed against each bond is called its face value or par value.

The face value of a bond is fixed and is written on the bond. Besides this, the borrower has to pay a regular payment throughout the life of the bond to the lender. These regular payments are called coupon interest payments whose rate is fixed at the beginning in the shape of annual interest rate. Finally, on the maturity of a bond, the borrower returns back the principal amount to the lender.

Value of Bond

The value of the bond or Bond Valuation is derived from the cash flows linked with it. These cash flows are in the form of interest payments and in the shape of the final return of principal amount to the bondholder. So, now the question is that from where these cash flows come from?

The answer is quite simple as bond is a direct claim security, which is backed by any kind of physical asset of a borrowing enterprise. The underlying asset of that enterprise is involved in the creation of certain cash flows. Basically for the business in the form of revenue. So, the cash flows of the bond are derived from the operations of the business and its value is based on the underlying asset’s value.

Appearance of Bond in the Balance Sheet

The appearance of bonds on the balance sheet is a delicate matter that needs some care. The bond is issued by a company, then the issuing bond should be considered as debt. In fact for that company and it appears on the liabilities side of the balance sheet. On the other hand, if the company is investing in a particular bond, then this type of bond is treated as an asset for that company. Moreover appears on the asset side of the company as marketable securities. Here remember that the appearance of bonds in the balance sheet also shows the difference between bonds and shares.

Example

Suppose an embroidery thread company wants to increase its business. For this purpose new embroidery machines will be purchased in order to increase the production of the embroidery thread. There is a capital of 2,000,000 $ for new machinery.  Management of the company has two options for this purpose. One source of acquiring funds is through the issuance of shares of the company. In this method the firm does not need to give regular interest payments to the shareholders. Instead, it will give them dividends on an annual basis. The second method of obtaining capital is by raising debt. For this purpose the company needs to issue 2,000 bonds, each having a face value of $ 1,000 in order to complete the target of $ 2,000,000.

Suppose the company decides to raise money through debt and felt the need to issue 2,000 having a par value of 1,000 $ each. Let the interest rate offered by the company is 12% P.A. And the life of each bond has been for five years. Then the company offers its bonds to the general public. Also in return receives the respective amount from the purchasers of the bonds as the principal amount. From this principal amount, the company purchases new embroidery machinery and increases its production level. Actually that results in an increase in the revenue of the company.

As the company has raised capital in the form of debt through bonds. Then it has to pay regular interest payments to its bondholders. Particularly at the rate of 15% on par value of the bond. After five years, the company returns back the principal amount to the bond holders against the bond certificates.

Share/Stock

A smaller part of capital is known as share, and a person who shares is known as Shareholder. It is a direct claim security in the form of a paper certificate that shows the ownership. It is actually a piece of paper in the form of a contract that a person can purchase. Moreover can become a part of a company in the shape of its shareholder. A share contains a par value that is mentioned on the face of the share. So the company pays annual dividends to its shareholders based on the profit of the company. As well as the decision of its board of directors. The shares are also traded on the stock exchanges. Owing to those buying and selling each share of a company has a certain market price. Actually that is different from its par value.

There is a big advantage attached with the raising of capital through issuance of shares. The company does not need to pay fixed regular payments to its shareholders. Whereas in case of bond issuance the company is obligated to pay certain fixed regular payments to its bondholders. Therefore it is the main difference between bonds and shares.

Value of Share

Like a bond, the value of a share is also based on the underlying physical asset of an issuing company. The cash flows generated by that asset give the foundation of the cash flows generated by a share. That’s why it is called a direct claim security. However the bondholder has first claim on the assets of a closed company than its shareholder.

Appearance of Shares in the Balance Sheet

If the share is issued by a company, then the share becomes liability of the company and comes on the liability side of the balance Sheet. And if the company is purchasing the share of any other company. Then the share becomes an asset for the purchasing company. Although appears on the asset side of the balance sheet in the form of marketable securities.