Differences Between an Equity Market and Bond Market
In the equity market, also known as the stock market, a company issues shares that are then traded on the stock exchange. Stocks are securities that represent a claim on a corporation’s assets and earnings. When an investor buys these shares, they have an ownership stake in the company giving them a potential to make capital gains based on its future performance.
The bond, or debt, market is where debt securities are issued and traded to participants. This means that investors have entered into a contract with an entity by loaning them money in exchange for a pre-established interest payment to be received at regular intervals with the full bond to be paid back on a specific date. These make up the three components of a bond: the principal, yield, and maturity date. The government issues bonds—in the form of treasury and municipal bonds—and corporations also issue bonds as well.
Sizes of the Markets
The equity and bond markets are vastly different in size. While the stock market and the New York Stock Exchange (NYSE) are widely known and recognizable, the bond market is on average more than twice as big of a market. The bond market in the United States is worth roughly $40 trillion with the global bond market reaching $100 trillion. The U.S. stock market, on the other hand, has a value of less than $20 trillion. One of the reasons that the bond market is so much larger than the equity market is the perceived risk. Both the government and corporations issue fixed income securities, whereas only corporations issue stocks. The U.S. Treasury is the largest issuer of bonds in the world and because it is backed by the credit of the government, investors see them as risk-free and prefer the regular income from interest payments of bonds.
Buying Stocks and Bonds
Stocks are traded in the equity market in the stock exchange. These can be located in physical places, such as the New York Stock Exchange (NYSE) and the virtual world, such as NASDAQ, where stocks are traded electronically through computer networks. There are multiple stock exchanges all over the world and most of the large, global corporations have stocks listed in a multitude of worldwide stock exchanges. Bonds are sold in two ways. New bonds can be sold in the primary market either by an auction, where buyers bid on portions of bonds for sale, or a bought deal, which involves an investment firm purchasing all bonds at a set price. These bonds are then traded in secondary markets where ordinary and large investors alike are able to purchase them. Unlike stocks in the equity market that trade on exchanges, bonds trade mostly over the counter, where informal networks of dealers trade in one-off deals. The majority of bonds are purchased by institutional investors, which include mutual funds, pension funds, endowments, and insurance companies.
Risks of Investing in Equity and Bond Markets
While there are risks associated with each market, bonds are considered to hold less risk than stocks traded on the equity market. The stock market is volatile and subject to the performance of the company whose shares the investor owns. Also, the company who has issued shares decides how much the dividends will be each quarter. There are no guarantees that the dividend will increase. A bond is similar to a contract in that the company has specified a maturity date when the debt will be paid back along with an establish rate of return. Another reason bonds are thought to be less risky is that when companies run into unforeseen trouble, the bondholders are paid back first. Government-issued bonds, such as municipal and treasury bonds, are regarded as the safest investment because the government backs them.
Impact on the Economy
Both the equity and bond markets are of critical importance for the economy. The bond market determines interest rates, which influences economic decisions to save money or make major purchases, such as buying property and cars. Interest rates also have a substantial impact on the how consumers spend their money and how businesses invest. Similarly, the equity market influences consumer and investment spending decisions. Because many U.S. households keep their wealth in assets such as stocks and bonds, if the markets are performing poorly, then the consumers spend less. The reduced wealth of consumers can slow down economic growth.
The differences between the equity and bond markets are significant. Finance professionals and private investors should be aware of the benefits and risks of each market before investing. The success they will have in growing their investments depends upon an understanding of market trends and changes in the domestic and global economy.