Singapore-based financial blog that aims to educate people on personal finance, investments, retirement and their Central Provident Fund (CPF) matters.

Tuesday, 24 May 2016

Shares Risky & Bonds Safe?

Since the beginning of this year, there has been several bond issues in Singapore.
While the interest rates on these bonds are high, we think there are actually more research into not the bonds themselves but the companies that are issuing these bonds.

What are Bonds
IOUs of a company issued to you.
The company owes you money.
The company needs to pay you a stated interest every year.
The company will at the maturity of the bond, pay you back the amount you lent them.
If the company goes bankrupt, you are the first in line to collect money from its assets.

Shares
Certificate of ownership of a company.
Entitles you to the profits the company make.
Does not need you to contribute money back into the company if the company makes losses.
If the company goes bankrupt, you do not need to pay its debtors using your own money.
If the company goes bankrupt, you will lose the amount of money you invested in the company.

A lot of people around you will say that shares are riskier than bonds, including friends you have from the financial industry.
This idea is technically not wrong, but statistically misleading.

Why People say Shares are Riskier?
Shares are riskier because of 3 reasons:

1. Their price movements are more volatile
Prices can swing from +10% to -10% within one trading day.
In extreme cases like during a recession, prices drop for more than 30% and remain that low for a year or so.
On the other hand, bonds tend to have low price movements. It also has a maturity date attached to (most) bonds. Thus if you hold long enough till maturity, the company will return you the full amount you lent to them previously.
BUT! Share prices also tend to recover back up (if you bought index funds instead of individual companies' shares)
Just look at the chart below to see how S&P500 prices move since 1950s to now for evidence.

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2. Dividends not guaranteed
While bonds WILL pay you a fixed interest during their payment dates (quarterly, half-yearly or yearly); shares might not pay you any dividend when the company is facing financial hardship or if the management decides to keep the cash and re-invest into the business.
Because of this, bonds are considered safer then shares in that you get fixed predictable income every payment date.

3. Not first in line when company goes bankrupt
If you own a company's bond, when the company goes bankrupt, you are the first in line to collect back your money by selling their assets.
This can happen when the company goes bankrupt or miss a interest payment.
However, if the company has insufficient asset to repay the loan, you will not get back the full amount you invested into their bonds.
If you own a company's shares, when the company goes bankrupt, you are the last in line to collect back your money after they sell their assets and pay the bond holders.
If there is insufficient assets to repay the bond holders, you do not need to cough out your own money to repay the loans. But you will not get any money back from the company.
However, if there is plenty of cash left over after repaying bond holders, the cash will be distributed to shareholders (there is a possibility that the cash distributed to you might be more than the price you paid for your shares).

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Conclusion
Base on the above 3 points, do you think that shares are still riskier than bonds?

Remember to offer your opinions. If you don't put your two cents in, how can you expect to get change?

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