A brief overview of equities and bonds
Equities and bonds are two of the most common types of investments. Equities (or shares) give you part ownership in a company, while bonds are loans you make to a company or government in return for regular interest and eventual repayment.
Equities typically come with the potential for higher returns, but at a greater risk, with the possibility of prices going down as well as up. Bonds tend to offer a more stable investment, but with less potential for significant gains.
As the risk profile differs for each, equities and bonds are often positioned together in investment portfolios to balance risk and reward.
Keep in mind that the value of your investment can go down as well as up, so you could get back less than you invested.
Equities and bonds handy jargon-buster
A quick explainer of some of the terms you may come across when looking into equities and bonds.
- Equities – Another word for shares in a company, giving you part ownership
- Bonds – IOUs issued by a company or government, where you lend them money in return for regular interest payments and repayment at the end of the term
- Gilts – UK government bonds
- Face value – The original price of a bond (or gilt) when issued
- Maturity date – The date on which a bond issuer repays the face value to the investor
- Term – The length of time until a bond's maturity date
- Capital gain – The profit made when you sell an investment for more than you paid
- Capital loss – The loss made when you sell an investment for less than you paid
- Dividends – Payment made to shareholders from company profits
- Diversification – Spreading investments across different assets to reduce risk
What are equities?
Equities are more commonly known as shares in the UK and represent part ownership of the company that issued them. Investors buy and sell equities on stock markets worldwide. The primary trading exchange for the UK is the London Stock Exchange (LSE).
When you buy a share, you receive an equity stake in that company. This gives you a portion of its total ownership value after all debts and liabilities are accounted for.
What's the appeal of equities?
One of the main appeals of being a shareholder is the potential for your investment to grow. Although there are a number of factors that can lead to an increase in share value (see below), one of the key ones is a company that performs well.
A company that's performing well may also choose to share it profits among investors. These payments, known as dividends, offer the potential for a regular income.
Equities can be traded individually, but access to the markets for many is often via an investment fund. These can have a mixture of underlying assets, selected to diversify the fund and help to spread the risk.
If it's a managed fund, it'll remove the need for you to keep track of share prices. The responsibility for buying and selling shares will sit with the fund manager, whose job it is to provide the best return for you and other investors in the fund.
What causes change in share prices?
The price of a share can rise or fall depending on market conditions. Key factors affecting share value include:
- Company performance – Drivers such as earnings, profitability, strategy, and business outlook can impact on share prices
- Market stability – Volatile markets can cause sharp increases or decreases in shares across the board
- Supply and demand – When more investors want to buy than sell, prices tend to rise. When more want to sell than buy, prices tend to fall
- Investor confidence – Confidence, or lack of it, in a company can have a positive or negative effect on share value
- External events – Events outside the company's control, such as war, pandemics, or government policy, can cause dramatic shifts in share prices
The general rule with equities is if the company is performing well, it will often attract other investors. This can cause the share price to rise, as investors see the opportunity to benefit from any dividends or capital gain.
Equities are typically seen as a higher-risk investment than bonds. But this risk has the potential to be rewarded with higher returns.
What are bonds?
Bonds are a type of investment where you loan the bond's issuer money. In return you get either fixed or variable-rate interest payments, and repayment of the loan when the bond's term is up.
There are two main types of bond. These are corporate and government bonds.
The latter are known as gilts in the UK. A company or the government issues them when it needs to raise capital. This money helps fund projects such as business growth or public services.
How do bonds work?
When you buy a bond, you are lending your money to the issuer (a company or the government). This is in return for regular interest and the repayment of the bond's face value on a future date (the maturity date). The face value is the price of the bond when it's first issued.
As long as the company you are lending to doesn't default, the interest payments will continue until the bond matures. At that point, you will be repaid the face value. Bonds, especially gilts, usually offer a low-risk investment, providing a steady and stable income throughout their term.
Like equities, bonds can also be traded. They are bought and sold on the second market via exchanges such as the London Stock Exchange's debt markets.
The face value of a fixed-income bond stays the same during its term. However, the bond's price can go up or down in the secondary market. This is because of changes to interest rates.
How do interest rates affect the price of bonds?
Bonds and gilts have different maturities. They can last less than five years, which is short term, or up to 50 years for some gilts. Over a bond's term, the base rate of interest, set by the Bank of England, can rise or fall depending on economic conditions.
This can have a direct impact on the price of a fixed-rate bond on the secondary market. Here's how it works:
When interest rates rise:
- A rise in the base rate of interest has a knock-on effect across the board
- Any new bond entering the market will offer a higher interest rate to reflect this
- Bonds already on the market, offering lower interest payments, become less attractive to investors
- The market price of existing bonds falls to make them more competitive
When interest rates fall:
- A fall in the base rate of interest has a knock-on effect across the board
- New bonds entering the market offer lower interest rates than existing bonds to reflect this
- The market price of existing bonds rises because investors are attracted to the higher interest payments
Variable-rate bonds tend to behave differently. Some have interest payments adjusted in line with interest rate changes. Others, such as Index-linked bonds, have their payments tied to inflation.
Equities vs bonds: Comparing the two
Both equities and bonds offer their own benefits. Likewise, they also offer their downsides. The comparison table below highlights some of these:
| Feature | Equities | Bonds |
|---|---|---|
| Risk | High short-term volatility | Less volatility, greater stability |
| Returns | Potential for higher long-term returns | Typically lower returns |
| Income | Possibility of dividend payments | Regular and stable income from interest payments |
| Reliability | Risk of loss if company performs badly | Considered a safer investment option, although not completely without risk |
| Market influence | Investor confidence can affect price swings | Less vulnerable to market pressures |
| Effort | May require ongoing monitoring and active management unless invested via a managed fund | Requires research upfront, but usually less active management if holding for a steady income |
| Other risks | Ownership value can be reduced if a company issues more shares (equity dilution) | Can be susceptible to interest rate fluctuations and inflation |
As the table shows, there are trade-offs to be made regardless of whether its equities or bonds you're investing in. For instance, the relative stability offered by bonds is offset by lower returns. While the potentially higher returns from equities comes at the expense of higher risk.
Equities vs bonds: Balancing risk with an investment fund
With the potentially higher rewards offered by equities and the lower risk offered by bonds, investing in both could be a smart way to add balance to your portfolio.
If buying individual shares and bonds doesn't appeal, then an investment fund may be the answer.
With an investment fund, you and other investors pool your money to buy a range of assets. You don't own the underlying assets, so you can't sell individual shares or bonds when you want. Instead, you own units of the fund, proportional to your investment.
An actively managed investment fund will have a fund manager responsible for buying and selling the assets and providing the best return for the investor. Traditionally, investment funds focussing on a balance between equities and bonds have used the 60/40 model – 60% equities and 40% bonds. In recent years, due to changing market conditions, this approach has been reassessed, with fund managers adjusting asset allocation to better manage risk and reward.
Managing risk and reward with a diversified portfolio
The split between equities and bonds depends on the fund's individual risk profile. Higher-risk funds typically hold a much larger proportion of equities and may include other assets considered high risk. Lower-risk funds tend to have bonds making up the lion's share of assets.
Equities and bonds together can help balance the fund's portfolio. The equities provide potential growth and can increase the fund's unit price, while bonds can help counteract stock market volatility.
If you want to cover your options, a diversified approach can help balance risk and reward, providing a potentially firmer foundation on which to build wealth.