NSE #7: Understanding stocks and bonds

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Yeah, we are progressing!

When it comes to financial securities investment, stocks and bonds matter a lot.
And in today's post, I'll be helping you understand stocks and bonds. What they really are.

image: blog.mumbaitrader.com

There are different ways to own a company: you can start one yourself; you can partner with a friend to start one; and you can buy the stock or bonds of a company. And for most of us, buying stock or bonds are the easiest way to own a company, at least a piece of a company.

Occasionally, we see a company growing very fast. And its bankers advise it to float an IPO (Intial Public offer). They come up with a mind-numbing valuation of the company and break it down into million units of shares. They sell a part to the public, you and me. Every share of the company you buy is a portion of the company. If you are extremely rich, you can decide to buy all the company's shares and make it your family business. That's if the board of directors let you.
Buying a company's stock is owning part of the company, it's like becoming a limited partner with less legal rights.

Then when the same company sees a huge business opportunity and wants to quickly cash in on it, it may float bonds for the public to buy. Bonds are like loans, [often] from the small guy to the big guy. You as an individual are lending money to a multi-billion naira company. And that's simply what buying bonds is.

Now to the less obvious.
We can break down the ownership of a publicly traded company into three different classes --
  1. Bond Investors
  2. Preferred Stock Investors
  3. Common Stock Investors
Bond Investors are regarded as senior owners and lay a prior claim to the assets of the company before both the preferred stock and common stock investors can enforce their claims. Likewise, the preferred stock owners are superior to the common stock owners.
If for any reason the company has to shutdown and its assets be sold off. The bond investors will first be satisfied, then preferred stocks investors and lastly, the common stock investors. In most cases like this, nothing reaches the common stock owner.

In practical terms, if you buy the bonds of a company, the only way you'll lose your investment (if you don't trade it at a discount) is if the company closes down completely (nowadays, it's also called restructuring).  But as a stock owner, you either jump ship before it's too late or watch all your investment vaporize.

On the other hand, if the company is doing extremely well and growing revenue to the sky. A bond owner will not get more than he was promised. While a stock owner will reap almost all the rewards.

And that is why bonds are viewed as conservative investments, and stock as very risky. But the reality is that a company that is healthy enough to fulfill its bond obligations will most likely be faring very well in the stock market, while a company whose stock is getting seriously bashed might end up not meeting it's bond obligations (except in some crazy exceptions).

In conclusion, when it comes to buying bonds, you are better off sticking to government bonds. If there is a company you believe it's bonds are investment grade, you should rather consider investing in its stock (except it's overpriced). So in reality, use the bond ratings of a company as an indicator of the company's health, to see if you can continue with your plan to buy it's stock. 


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