Bonds Compared with Stocks

Bonds Compared with Stocks

Bonds Compared with Stocks

Bonds Compared with Stocks

It is perfectly clear that bonds are less risky than stocks when bothclasses of securities are issued by the same corporation. Since bondholders have a prior claim to the earnings and assets of the corporation, the rates of return on bonds are less variable and more confidentlypredicted than rates of return on the common stock. This fact is soobvious that it has not been studied and does not require study.

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A more interesting question is whether bonds as a whole are lessrisky than stocks, and what the relationship is between rates of returnon bonds and rates on stocks. It is possible, though not true, thatbonds are issued only by corporations whose earnings are extremelyuncertain, while corporations with only common stock in their capitalstructure have extremely stable and predictable earnings. It is thustheoretically possible that bonds as a group are as risky as commonstocks. In the real world, things are not this way, since debt-equityratios tend to be highest for corporations with relatively stable earningsthe utilities, for example. Thus, we would expect to find that,on the average, rates of return for bonds are less than for stocks because returns on bonds are more predictable or less risky. If one compares the results of buy-and-hold policies for bonds and stocks forthe period January 1926 to December 1965, investments in bondswould have outperformed investments in stocks in only 23 of the 820possible holding periods of one or more years.

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For the most part,the periods when investment in bonds would have been profitableare of short duration. The exceptions are six periods when the initialinvestment was made prior to 1931. The lesson is obvious. If onecan predict a major depression, investment in bonds can be relatively rewarding by providing superior rates of return. Otherwise, stocks provide higher returns.

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