Bonds Vs Equities:
Stacking up your risk
One of the most compelling ways to understand your investment risk is to measure where you stand in a company’s capital structure if it enters troubled waters.
If you’ve ever wondered why equities have historically provided higher expected return to investors than bonds, look no further than a company’s capital stack. A capital stack represents all the different sources of funding that a company may have in order to carry out its business. Each layer represents a different type of security that a company has issued.
What’s really important to note is that there is a hierarchy in the stack. Those invested in stacks higher up the pecking order come before those in the lower stacks for any obligations that company may pay its investors. This can include coupons or dividends.
Generally, bond holders are in a sense buffered by equity holders. In the rare and extreme event of liquidation, bonds holders will be paid out before equity holders.
That difference in seniority explains why equities are generally higher risk than bonds. The corollary is that equity holders expect a higher return to compensate for the higher risk. Otherwise they’d just invest in bonds if the return was the same.
A bank example
An Australian bank provides a good example of a capital stack because banks tend to issue different classes of securities across the capital spectrum. Banks can raise money through Secured Debt, Deposits (Cash / Term deposits), Senior and Subordinated debt, Preference Shares and Equity.