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Are you looking to invest your money and secure your financial future? If yes, you must have come across various investment options with different terminologies. Whether it’s the stock market, where you hear terms like IPO, Demat account, and shareholders, or the bond market, where terms like coupon rate, yield, and bondholders are commonly used.
This article will clarify these two terms and highlight how they function to help you make tactful investment choices. So, read on to uncover the differences between bondholders and shareholders..
Defining shareholders and their role
When you buy shares, you become a part-owner of that company. The company will sell shares to the public for the first time through an IPO, and those shares will be available for trading on the stock exchange. People can buy and sell these shares based on the current market price.
Those people or organisations that own these shares are called shareholders. As a shareholder, you are entitled to receive a share of the profits earned by the company, which is called a dividend. However, the company’s financial performance and management decisions determine whether or not they will pay dividends. Shareholders can even sell their shares to other people whenever they want to.
In addition, organisations like governments, groups of people, or other entities can also own shares in a company. But once you sell your shares, you tend to lose your shareholder rights, like the right to receive dividends.
Understanding bondholders and their functioning
Unlike shares denoting ownership, bonds represent debt instruments where companies borrow funds from lenders. The bond issuer promises to pay the lenders a predetermined interest on the principal regularly. In bond vocabulary, this rate of interest is termed the coupon rate.
Moving on to bondholders, individuals or institutions purchase the bonds floated by a company. When you invest in bonds, you enable the issuer to raise capital for business needs. In return, they must legally pay you the promised coupon rate at fixed intervals. In most cases, bonds carry a fixed interest rate during their tenure.
As a bondholder, you can earn in two ways: holding the bond till maturity and earning regular interest income or selling the bond at a higher price in the secondary market for capital gains. However, like shares, once sold, all rights attached to being a bondholder are relinquished.
Functioning between shareholders and bondholders
While both shareholders and bondholders fund companies, they differ significantly in rights and responsibilities. Firstly, buying bonds doesn’t make you an owner of the business, unlike buying shares. Bondholders only engage while purchasing or selling bonds later for profit-booking.
Conversely, shareholders enjoy partial ownership privileges like participating and voting in Annual General Meetings, having a say in executive appointments, etc., beyond financial incentives.
Secondly, when it comes to payment precedence, companies are legally required to service bondholders first with coupon interest, irrespective of profitability. However, dividends are discretionary and paid from residual earnings only after fulfilling all obligations.
Another key difference is that bonds assure fixed returns, while share returns are variable depending on business fortunes and market dynamics. Thus, bonds present lower risk and a capped upside but guarantee the income stability that conservative investors desire. Shares carry higher risk but provide higher reward prospects if the underlying company performs well. Hence, both instruments suit differing investment objectives and risk appetites.
Examining potential sources of conflict between the two groups
Sometimes, people who invest money in a company by buying shares or lending money through bonds can have different ideas about what the company should do.
For example, when a company gives lots of money back to people who own shares, those shareholders are happy because they can get more money. But if the company also owes money to people who bought bonds, those bondholders might worry that the company won’t be able to pay them back.
Another thing that can cause problems is when a company takes big risks to try to make more money. Shareholders might like this because they can get more money if things go well. But bondholders might be worried because if things go badly, the company might be unable to pay back the money it owes them.
So the people who run the company have a tough job because they have to try to make both groups happy when they make important decisions about money. It can be challenging to find a way to make everyone happy.
Best practices for companies to manage shareholder-bondholder conflicts
Some ways businesses can effectively manage conflicts between the two parties include:
1. Maintaining reasonable debt ratios as per industry benchmarks
2. Instituting dividend and investment policies protecting bondholder interest
3. Developing contingency plans identifying triggers for financial stress
4. Assigning higher weightage to bondholder interests in case of serious disputes
5. Having open channels of communication with both groups
When you follow these principles, you can have good relationships, get funding when needed, and manage your money wisely for long-term success.
Key takeaways
Understanding the real distinction between shareholders and bondholders is important before investing as their features and rights differ:
- Shareholders own part of the business and may influence decisions, while bondholders are external lenders entitled to fixed returns only
- Returns for shareholders are variable as per profits, while bondholders get regular interest income contracted beforehand
- Shareholders’ claims are subordinated while repaying bondholders’ capital and interest is the priority
- Bondholder goals are narrowed to income generation, while shareholders aim for value appreciation
Conclusion
When you invest in a company, you can do it in different ways. You can either become a shareholder or a bondholder. But it’s important to know that these two options have different rights and benefits. By understanding these differences, you can make smarter investments in your choices that align with your financial goals. It’s essential to be well-informed because it can lead to better results for your investment portfolio. Knowing the difference between a bondholder and a shareholder helps you decide where to put your money and achieve the best outcome for your investment while managing the risk.
A shareholder owns part of a company by purchasing its shares. They can influence decisions and aim for capital appreciation. A bondholder lends money to a company by buying its bonds. They receive fixed interest and return of principal. Their goal is income generation rather than ownership.
Bondholders get higher priority during repayment than shareholders. Companies have to repay borrowed capital and interest to bondholders first legally. Shareholders earn only residual profits after obligations to all creditors are met. So, in case of bankruptcy, bondholders have precedence over shareholders.
Shareholders may favour high-risk moves like mergers or added leverage, expecting higher profits. But more debt makes bondholders anxious due to higher default chances if those ambitious bets fail. High dividends also benefit shareholders but reduce the capital cushion for honouring debt. This causes friction between the two groups.
Yes, an individual or entity can be a shareholder and a bondholder in the same company. It provides them the advantage of enjoying fixed income from bonds while benefiting from the company’s profitability and capital appreciation potential as an owner.
For conservative investors who prioritise safety, bonds present lower risk and guaranteed returns. In contrast, equities or shares can provide higher but more variable returns depending on the company’s fortunes. So bonds suit low-risk tolerance while equities match higher risk appetite better in exchange for higher reward potential.