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

Preferred Stocks vs. Bonds: An Overview

Corporate bonds and preferred stock are two of the most prevalent methods of raising cash for a business. Income-seeking investors may benefit from either: Bonds pay interest on a regular basis, while preferred stocks offer set dividends. However, it is critical to understand the similarities and distinctions between these two forms of securities.

Key Takeaways

• Companies raise funds by selling corporate bonds and preferred stock to investors.
• Bonds make monthly interest payments to investors, but preferred stocks pay fixed dividends.
• Bonds and preferred stocks are both interest rate sensitive, increasing when rates fall and falling when rates rise.
• If a corporation declares bankruptcy and is forced to close, bondholders are paid first, before preferred shareholders.

Preferred Stocks

Holding stock in a corporation implies ownership or interest in that company. An investor may possess two types of stocks: ordinary stock and preferred stock. Common investors have the ability to elect a board of directors and vote on corporate policy, but they are lower in the food chain than preferred stockholders, especially when it comes to dividends and other payouts. On the negative side, preferred investors often do not have voting rights.

When a corporation is liquidated, preferred shareholders and other debt holders get priority access to corporate assets over regular shareholders. Preferred shareholders also have a higher priority when it comes to dividends, which are paid monthly or quarterly and often yield more than regular stock.

Bonds

A corporate bond is a kind of financial securities that a firm creates and sells to investors. The company’s creditworthiness, or capacity to repay the bond, is commonly used as collateral for the bond; however, collateral for the bonds may also originate from the company’s tangible assets. Corporate bonds, unlike corporate stock, have no ownership or voting rights in the corporation. Regardless of how well the firm does in the market, the investor only gets interest and principle on the bond.

Investors should avoid corporate bonds in favor of government bonds. The bigger the risk, the higher the bond’s interest rate. This is true even for corporations with great credit.

Key Similarities

Interest rate sensitivity

When interest rates rise, bond and preferred stock values decline. Why? Because future cash flows are discounted at a greater rate, they provide a larger dividend yield. When interest rates fall, the reverse occurs.

Callability

Both securities may contain an imbedded call option (making them “callable”), which allows the issuer the opportunity to call back the security and issue new securities at a reduced rate if interest rates decline. This not only limits the investor’s upside potential but also introduces the danger of reinvestment.

Voting rights

Neither security confers voting rights on the holder.

Capital appreciation

These instruments have relatively limited capital appreciation potential since they feature a set payout that does not benefit from the firm’s future development.

Convertibility

Both instruments may enable investors to convert the bonds or preferreds into a specified number of shares of the company’s common stock, enabling them to participate in the firm’s future development.

Key Differences

Seniority

In the event of a firm going bankrupt and being forced to shut, both bonds and preferred stocks are senior to common stock; this implies that investors owning them rank higher on the creditor payback list than common-stock stockholders. Bonds, however, take preference over preferred stocks: Bond interest payments are legal requirements that must be met before taxes, but dividends on preferred stocks are after-tax payments that do not have to be made if the firm is experiencing financial problems. Depending on whether the investment is cumulative or non-cumulative, any missed dividend payment may or may not be paid in the future.

Risk

Preferred stocks are typically rated two notches below bonds; this lower rating, which signifies more risk, reflects their smaller claim on the company’s assets.

Yield

To compensate for the additional risk, preferred stocks provide a higher return than bonds.

Par value

Both securities are often issued at face value. Preferred stocks often have a lower par value than bonds, requiring a lesser initial commitment.

Special Considerations

Preferred stocks are popular among institutional investors because to the favorable tax treatment they get on dividends (50% of dividend income may be deducted on corporate tax returns). Individual investors are not eligible for this benefit.

The fact that corporations are raising money via preferred stock may indicate that they are heavily in debt, which may impose legal restrictions on the amount of new debt they may borrow. Preferred stock is mainly issued by companies in the banking and utility industries.

However, the high yield of preferred stocks is a plus, and they may add value to a portfolio in today’s low-interest-rate climate. However, adequate investigation about the company’s financial status is required, otherwise investors may incur losses.

A mutual fund that invests in preferred stocks of numerous firms is another possibility. This provides both a high dividend yield and risk diversification.

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