Preferred stocks and bonds: what is the difference?

Preferred stocks and bonds: an overview

Corporate bonds and preferred stocks are the two most common ways for companies to raise capital. Investors seeking income can take advantage of one of the following: bonds pay regular interest and preferred stocks pay fixed dividends. But it is important to understand the similarities and differences between these two securities.

Key points

  • The company provides investors with corporate bonds and preferred stock as a way to raise capital.
  • Bonds provide investors with regular interest payments, while preferred stocks pay fixed dividends.
  • Both bonds and preferred stocks are sensitive to interest rates and rise when they fall, and vice versa.
  • If a company declares bankruptcy and must close, bondholders will receive returns before preferred shareholders.

Preferred stock

Holding stock in a company means owning ownership or equity in that company. Investors can own two types of stocks: common stocks and preferred stocks. Common shareholders can elect the board of directors and vote on company policies, but their status in the food chain is lower than preferred shareholders, especially in dividends and other payments. The downside is that preferred shareholders have limited rights, which usually do not include voting rights.

When the company is in liquidation, preference shareholders and other debt holders enjoy the rights of the company’s assets before common shareholders. Preference shareholders also have priority in dividends. Dividends often yield higher returns than ordinary shares and are paid monthly or quarterly.

Bond

Corporate bonds are debt securities issued by companies and offered to buyers. The bond collateral is usually the company’s reputation or the ability to repay the bond; the bond collateral can also come from the company’s physical assets. Unlike company stocks, corporate bonds have no equity or voting rights in the company. Regardless of the company’s performance in the market, investors will only receive the interest and principal of the bonds.

Compared with government bonds, corporate bonds are a riskier investment for investors. The higher the risk, the higher the bond interest rate. This is especially true for companies with good credit quality.

Main similarities

Interest rate sensitivity

When interest rates rise, both bond and preferred stock prices fall. why? Because their future cash flows are discounted at higher interest rates, providing better dividend yields. When interest rates fall, the situation is just the opposite.

Callability

Both securities may have an embedded call option (making them “callable”), giving the issuer the right to reclaim the securities if interest rates fall and issue new securities at a lower interest rate. This not only limits the upside potential of investors, but also brings about reinvestment risks.

Vote

Neither type of securities provides holders with voting rights in the company.

Capital appreciation

The space for capital appreciation of these instruments is very limited because they have fixed payments and cannot benefit from the company’s future growth.

Convertibility

Both securities can offer the option of allowing investors to convert bonds or preferred stock into a fixed number of shares of the company’s common stock, which allows them to participate in the company’s future growth.

Main difference

Qualifications

In the case of liquidation proceedings—the company goes bankrupt and is forced to close—both bonds and preferred stock have priority over common stock; this means that investors who hold them are ranked higher on the creditor repayment list than common shareholders. But bonds have priority over preferred stocks: bond interest payment is a legal obligation and should be paid before tax, while preferred stock dividends are paid after tax. If the company faces financial difficulties, it does not need to be paid. Any missed dividend payments may or may not be paid in the future, depending on whether the securities are cumulative or non-cumulative.

risk

Generally speaking, preferred stocks are rated two grades lower than bonds; this lower rating implies higher risk and reflects their lower requirements for company assets.

yield

Preferred stocks have higher yields than bonds to compensate for higher risks.

face value

Both securities are usually issued at face value. The face value of preferred stocks is usually lower than that of bonds, so lower investment is required.

special attention items

Institutional investors like preferred stocks because they receive preferential tax treatment on dividends (50% of dividend income can be excluded from the company’s tax return). Individual investors do not receive this benefit.

The fact that the company raises funds through preferred stock may indicate that the company is heavily indebted, which may also impose legal limits on the amount of additional debt it can raise. Companies in the financial and utility sectors mostly issue preferred shares.

However, the high yields of preferred stocks are positive, and in today’s low interest rate environment, they can add value to investment portfolios. However, it is necessary to conduct sufficient research on the company’s financial situation, otherwise investors may suffer losses.

Another option is to invest in a mutual fund that invests in preferred stocks of various companies. This provides the dual benefits of high dividend yield and risk diversification.

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