Many investors during the period of downturn in the market prefer to sell stocks and buy bonds. This practise is known as a “flight to quality” — when investors move from riskier investments to safer ones. Bonds are indeed consider to be a safer security than stocks, and understand the fact behind it , one must understand the concept of these two .
Definition
Stocks are a kind of securities that represent fractional ownership in a firm. Stock owners share in profits and losses a firm may incur. If a firm goes bankrupt, then you as a stock owner, lose your equity in the firm.
By contrast, a bond is a debt security — an instrument legally entitling a lender to the return of their principal plus periodic interest payments. Because this is essentially a loan, the bondholder is a creditor.
Bankruptcy
In the event of a bankruptcy, creditors have priority when determining the disposition of liquidated assets. While holders of secured bonds are entitled to receive the collateral asset(s) or their equivalent value, unsecured bondholders are at more risk of losing their principal, as their claims must be paid from the firm’s assets after the secured creditors — bondholders and other lenders holding collateralized loans — have been paid.
Stockholders’ claims on assets take the least precedence. After secured and unsecured creditors have been paid, stockholders are paid from the remaining assets, assuming there are any. You,as a stock owner, sharing in the profits and losses of the firm, can lose your entire investment in the firm’s shares.
Volatility
Because of the potential for price appreciation and speculation, stocks are more volatile than bonds. That is, their daily prices fluctuate more than those of bonds. If you are holding savings in stocks and need to access the funds quickly to satisfy an unanticipated expense, you could wind up selling your shares at a large discount simply because of a widespread rumor about the firm. Or you might miss out on a huge rally in the firm’s share price in the final hours of trading.
Bonds are subject to market risks, such as decreases in market price, which becomes important if you have to liquidate your holdings quickly. You could lose a portion of your principal if the bond price has sunk below the issuing price. Furthermore, the strength of the bond lies in the issuer’s ability to repay your principal and interest, which could change if the issuer suddenly suffers a reversal of fortune. You should also be aware that, generally, the higher the interest rate an issuer offers you, the riskier the bond is. Issuers with a questionable ability to repay their debts will offer you higher interest rates to entice you to invest.
Inflation
The safety of bonds is amplified during periods of inflation. Bond interest rates are often linked to inflation rates. When inflation increases, the competitive environment for business becomes more difficult: Raw materials cost more, and consumer purchasing power decreases. This can reduce company earnings and lead to reduced stock prices. When this happens, bonds are usually the ideal investment: Corporate bonds outpace inflation over long periods, and government bonds offer even more stability than corporate bonds, though their yields are lower.