Preferred Stocks vs. Bonds: What's the Difference?

Preferred Stocks vs. Bonds: An Overview

Corporate bonds and preferred stocks are two of the most common ways for a company to raise capital. Income-seeking investors can make good use of either: The bonds make regular interest payments, and the preferred stocks pay fixed dividends. But it's important to be aware of the similarities and differences between these two types of securities.

Preferred Stocks

Holding stock in a company means having ownership or equity in that firm. There are two kinds of stocks an investor can own: common stock and preferred stock. Common stockholders can elect a board of directors and vote on company policy, but they are lower in the food chain than owners of preferred stock, particularly in matters of dividends and other payments. On the downside, preferred stockholders have limited rights, which usually does not include voting. When a company is going through liquidation, preferred shareholders and other debt holders have the rights to company assets first, before common shareholders. Preferred shareholders also have priority regarding dividends, which tend to yield more than common stock and are paid monthly or quarterly.1

Bonds

A corporate bond is a debt security that a company issues and makes available to buyers. The collateral for the bond is usually the company's creditworthiness, or ability to repay the bond; collateral for the bonds can also come from the company's physical assets. Unlike corporate stock, corporate bonds don't have equity nor voting rights in the company. The investor only receives interest and principal on the bond, regardless of how well the company performs in the market. Corporate bonds are a more high-risk investment for investors than government bonds. The higher the risk, the higher the interest rates on the bond. This is even true for companies with excellent credit quality.

Key Similarities

Interest rate sensitivity - Both bonds and preferred stock prices fall when interest rates rise. Why? Because their future cash flows are discounted at a higher rate, offering better dividend yield. The opposite happens when interest rates fall. Callability - Both securities may have an embedded call option (making them "callable") that gives the issuer the right to call back the security in case of a fall in interest rates and issue fresh securities at a lower rate. This not only caps the investor’s upside potential but also poses the problem of reinvestment risk. Voting rights - Neither security offers the holder voting rights in the company. Capital appreciation - There is a very limited scope for capital appreciation for these instruments because they have a fixed payment that does not benefit them from the firm’s future growth. Convertibility - Both securities may offer the option of allowing investors to convert the bonds or preferreds into a fixed number of shares of the common stock of the company, which allows them to participate in the firm’s future growth.

Key Differences

Seniority - In case of liquidation proceedings—a company going bankrupt and being forced to close—both bonds and preferred stocks are senior to common stock; that means investors holding them rank higher on the creditor repayment list than common-stock shareholders do. But bonds take precedence over preferred stocks: Interest payments on bonds are legal obligations and are payable before taxes, while dividends on preferred stocks are after-tax payments and need not be made if the company is facing financial difficulties. Any missed dividend payment may or may not be payable in the future depending on whether the security is cumulative or non-cumulative. Risk - Generally, preferred stocks are rated two notches below bonds; this lower rating, which means higher risk, reflects their lower claim on the assets of the company. Yield - Preferred stocks have a higher yield than bonds to compensate for the higher risk.3 Par value - Both securities are usually issued at par. Preferred stocks generally have a lower par value than bonds, thereby requiring a lower investment.3

Special Considerations

Institutional investors like preferred stocks due to the preferential tax treatment they receive on the dividends (50% of the dividend income can be excluded on corporate tax returns). Individual investors don't get this benefit. The very fact that companies are raising capital through preferred stocks could signal that the company is loaded with debt, which may also pose legal limitations on the amount of additional debt it can raise. Companies in the financial and utilities sectors mostly issue preferred stocks. Yet, the high yield of preferred stocks is positive, and in today’s low-interest-rate environment, they can add value to a portfolio. Adequate research needs to be done about the financial position of the company, however, or investors may suffer losses. Another option is to invest in a mutual fund that invests in preferred stocks of various companies. This gives the dual benefit of a high dividend yield and risk diversification.

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Article partially appeared on investopedia.com

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