INSIGHTS

Shares and bonds are both important parts of any investment portfolio but there are some key differences between the two and sometimes it might make sense to own more shares than bonds, or vice versa.

What are the key differences between shares and bonds?

Shares are an ownership stake in a company. When buying shares you’re entitled to your share of the company’s profits which you will receive through dividends, or through capital gains on your investment. With shares, you are participating to a larger extent in the success, or otherwise, of the company in question. Shares therefore offer the most upside, but also carry a greater degree of risk.

With bonds (also known as fixed income), on the other hand, you are essentially lending your money to a company (or government). In exchange for this you will receive regular interest payments at a fixed rate for a set period of time. You do not participate in the company’s success in the same way as if you owned shares, but bonds carry a lower amount of risk and provide much more income certainty.

An example

To illustrate the differences, let’s look at an example.

Meridian Energy is listed on the NZX which means investors are easily able to purchase shares in the company. Meridian also regularly issues bonds in the local debt market.

Let's assume, based on our forecasts, shares in Meridian Energy provide a gross dividend yield of 4.6%. On top of this, an investor would also benefit from any future positive performance. For example, if demand for electricity continues to grow as major sectors look to decarbonise their operations, then shares would likely rise in value and dividends in future years would increase. Meridian’s share price has risen by 12.3% per annum over the past five years while the ordinary dividend has increased from 14.3 cents per share in 2018 to 17.4 cents per share in 2022.

However, should performance deteriorate – maybe due to the loss of major customers or expected electricity demand not coming to fruition as quickly as expected - shares could fall in value, potentially resulting in a negative return for investors.

Another option is to purchase bonds issued by Meridian Energy. The company’s most recently issued bond (in March 2023) currently provides investors with a yield of 5.22% until its maturity in around five years’ time. These interest payments are highly predictable and provide investors with a steady source of income. But they offer no upside if the company performs well.

Should you own shares or bonds?

An investor’s allocation between shares and bonds (along with other asset classes like property and cash) depends on a number of factors including time horizon, income requirements, and risk tolerance.

For example, a higher weighting to shares may be warranted if you have a longer-term investment horizon. This is because, while the return from shares is more volatile, they provide the greatest returns over the long-run.

However, if you expect to need to call on your investments in the next few years – perhaps a house deposit is on the cards – or you're reliant on the income from your investments for day to day expenses in retirement, then a higher weighting to bonds would make sense.