Question

Both stock and bond returns are based on the cash flows generated by the issuing firm. How do shareholders and bondholders differ in their claims of the firm’s cash flows? How do such claim differences cause the risk difference between stocks and bonds?  

Answer 1

Bondholders are entitled to a fixed cash flow over the term of the bond and a final redemption value equal to the par value of the bond. As per the indenture, the firm is obligated to pay the cash flows over the term of the bond. However, for stock holders, there is no such obligation on the part of the firm, as stockholders have ownership in the firm. So, they are entitled to get cash flows only after other creditors (such as bondholders) have been paid. This cash flow, too, is at the discretion of the firm so they dividends only if the firm decides so, otherwise their return is in the form of capital gains on the stock.

These basic differences cause risk difference between stocks and bonds. Since, returns from bonds are almost guaranteed (default risk is always there), bonds have lower risk (and hence, lower returns) than stocks. On the other hand, stock returns are not certain and guaranteed which means they have greater risk (Also, the returns can be greater than bonds).