Difference Between Equity and Fixed Income
Equity income refers to making of income by trading of shares and securities on stock exchanges which involves high risk on return with regards to fluctuation in prices whereas Fixed income refers to income earned on securities that gives fixed earning like interest and also they are less risky.
The majority of financial investments can be classified into two major asset classes – Equity and fixed income.
What is Equity?
Equity investments refer to buying stocks and stock related mutual funds. When an investor invests in a stock they own a share of the firm’s assets and revenues. They are convinced of the firm’s growth story and believe their investments can grow as the firm grows. However, it also comes with a risk that the company might go southwards, and all their investments will be gone. For example, if a company had a credit event and had to file for bankruptcy then investors lose all the money.
Equity can further be categorized into two types – Common stocks and preferred stocks. Common stocks grant the investors the right to vote in shareholders’ meetings in addition to a claim on profits. Preferential stock owners do get a claim on dividends (In fact their claim is more than common stock owners) but they do not have any right to vote.
What is Fixed Income?
Fixed income, on the other hand, is the securities that provide a fixed guaranteed result and hence the name “FIXED INCOME”. The cash flows are paid out for a fixed amount on regular intervals and the principal at maturity. The returns might not be that great but do provide a secured one. Fixed income can be bonds – zero coupon or coupon, corporate deposits and may be issued by a corporation or a sovereign entity – government or municipality.
The maturity for these can range from 3 months to several decades. Investment-grade bonds are considered to be the safest and give low returns while junk bonds give better returns but also have a low credit rating and a greater chance of default.
Equity vs Fixed Income Infographics
#1 – Ownership
Equity holders are considered as the owners of the company. They have voting rights on important matters and have a say in the functioning of the firm. They have the first right on profit and are paid out dividends. However, if the management decides on using the profit for some other activities like reinvesting in the business, or for any mergers or expansions they can’t be questioned. Hence dividends can be paid out but at the discretion of the management. Bondholders, on the other hand, do not get voting rights or any such share in the profit. They are creditors to the firm and are only guaranteed fixed returns and the principal amount at maturity.
#2 – Risk and Returns
Historically it has been proved that equity returns have surpassed returns of the fixed income. However, to gain those returns, risks undertaken by the investors have also been huge. Who can forget the great economic depression of 2007-08, or the dot-com bubble of early 2000? These have been times when stock markets have crashed by more than 25 – 30% to the extent of 40% at some rare times.
Similarly, there have been times when the stock markets would have given returns of more than 35 % in a single year. These volatile returns make investments in equity highly risky and volatile. There are mainly 2 types of risks here – systematic risks and unsystematic risks. Systematic risks arise because of market volatilities during various economic periods. Unsystematic risks refer to the risks that are characteristic of individual firms and can be avoided through diversification.
Fixed income, on the other hand, provides an element of certainty to your investments. Once you have invested in a bond, you are sure of the returns and the principal that you will be getting. During periods of economic expansion or recession, interest rates may vary but the guaranteed coupon payment that you have been entitled to receive, will not change. These stable returns of fixed income make them very attractive to risk-averse investors.
However, these fixed but low returns can mean that your investments might not able to keep pace with the inflation which in simple terms means that you are losing money year on year. The typical risk with fixed income securities is Default risk – the risk that issuer might default and may not be able to pay back the periodic cash flows and the principal at maturity. However, this risk is very low for sovereign securities like government treasury securities.
#3 – Bankruptcy
In case of a credit event like bankruptcy, if the firm or the issuer of the bonds defaults then the investments in both are lost. In such a case the assets of the firm are liquated to generate some cash. The amount thus received is first claimed by bondholders and once they have been compensated, the remaining amount is given to equity holders.
Equity vs Fixed Income Comparative Table
|Status||Equity owners have shared owners of the company which allows them to claim profits.||Bond owners are creditors that can only claim the loaned amount and interest earned on it.|
|Issuers||Equity is mainly issued by corporates.||Government institutions, financial institutions or Corporates issue bonds Corporate deposits are issued by firms.|
|Risk||Highly risky as it depends on the performance of the firm and the market conditions.||Low risk as they are promised a fixed interest irrespective of the firm’s performance|
|Claim to assets||In case of bankruptcy, they have the last claim to assets.||In the case of bankruptcy debt holders are prioritized over stockholders.|
|Returns||High returns to compensate for high risks in the form of cost appreciation.||Low but guaranteed interest returns.|
|Dividends||Dividends are cash flow of equity but paid at the discretion of management.||No dividends are paid.|
|Involvement||Since stock owners are the owners of the firm, they have voting rights.||Bondholders have no say in the company matters and voting.|
Both are important with respect to portfolio allocation. Also, returns in equity and fixed income, the investment categories are non-correlated to each other. Fixed income investments add predictability to your portfolio while equity investments help beat inflation and increase your financial worth by taking advantage of higher payoffs.
A prudent investor focuses on maintaining a balanced portfolio by investing in a combination of equity and fixed income products depending on his level of risk tolerance.
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