The Difference between Debt and Equity Markets
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?
Why are These Markets Important?
Both markets are of central importance to economic activity. The bond market is vital for economic activity because it is the market where interest rates are determined. Interest rates are important on a personal level, because they guide our decisions to save and to finance major purchases (such as houses, cars, and appliances, to give a few examples). From a macroeconomic standpoint, interest rates have an impact on consumer spending and on business investment.
Chart 2 below shows interest rates on select bonds with different risk properties for the last 10 years. The chart compares interest rates on corporate AAA bonds (highest quality bonds) and Baa bonds (medium-quality bonds) and long-term Treasury bonds (considered to be risk-free interest rate).
The stock market is equally important for economic activity because it affects both investment spending and consumer spending decisions. The price of shares determines the amount of funds that a firm can raise by selling newly issued stock. That, in turn, will determine the amount of capital goods this firm can acquire and, ultimately, the volume of the firm's production.
Another aspect to consider is the fact that many U.S. households hold their wealth in financial assets (see Table 1 below). According to the data from "Survey of Consumer Finances" published by the Federal Reserve System, in 2004, 1.8% of U.S. households held bonds (down from 3% in 2001), and 20.7% of U.S. households held stocks (down from 21.3% in 2001). Table 1 shows financial asset ownership data for 2004. In addition to this direct ownership of stocks and bonds, it's important to remember that there are households who hold these instruments indirectly – in retirement accounts, for instance (more than half of U.S. households held retirement accounts in 2001). Poor performance of equity and debt markets reduces wealth of households who hold stocks and bonds. This, in turn, reduces their spending (via the wealth effect), slowing down the economy.
