The Difference between Debt and Equity Markets
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While you read this page, pay attention to the difference between equity and debt and how and when companies issue either instrument. One of the advantages of holding bonds over stocks is that bondholders have priority in being paid over stockholders. This happens because bondholders are technically loan providers rather than owners, as is the case with stakeholders. From a legal perspective, loan providers are on top of the hierarchy in receiving their rights should the company be liquidated. When would companies prefer issuing bonds rather than stocks? What are three differences between debt instruments and equity instruments?
Debt vs. Equity
There are important differences between stocks and bonds. Let me highlight several of them:
- Equity financing allows a company to acquire funds (often for investment) without incurring debt. On the other hand, issuing a bond does increase the debt burden of the bond issuer because contractual interest payments must be paid – unlike dividends, they cannot be reduced or suspended.
- Those who purchase equity instruments (stocks) gain ownership of the business whose shares they hold (in other words, they gain the right to vote on the issues important to the firm). In addition, equity holders have claims on the future earnings of the firm.
- In contrast, bondholders do not gain ownership in the business or have any claims to the future profits of the borrower. The borrower's only obligation is to repay the loan with interest.
- Bonds are considered to be less risky investments for at least two reasons. First, bond market returns are less volatile than stock market returns. Second, should the company run into trouble, bondholders are paid first, before other expenses are paid. Shareholders are less likely to receive any compensation in this scenario.