Common stock, preferred stock and bonds are three ways to invest in companies. Common stock represents owning part of a company and often betting on its growth, while bonds and preferred stock are more about getting steady, reliable rates of return. Bonds and preferred stock are more attractive as overall interest rates go down. Many investors like to own some of all three to diversify their portfolios.
A bond is a way to lend money to a company or government agency. Bonds pay a fixed rate of interest and return the face amount on the maturity date. The time to maturity on bonds ranges from a few months to 30 years or longer. Bonds can be bought and sold before they mature.
Market trading prices are based on current interest rates in relation to the fixed rate a bond pays -- if market interest rates rise above the interest rate that the bond pays, its price goes down; if market interest rates drop below the bond's rate, its price rises.
Advantages of Bonds
One advantage of bonds is that there are a wide range of issuers, including large corporations; the federal government; foreign governments; and tax-free bonds from state and local governments. Another advantage of bonds is that they return their principal on their maturity date, unless the underlying entity goes bankrupt, which is a relatively uncommon occurrence. Even if the bond issuer remains sound, however, you need to be aware that you can lose out if you are locked into your bond's rates and the prevailing market interest rates increase. Higher rates will result in a lower market price for your bond if you want to get out early.
Common Stock Shares
Common stock, which is the stock you'll usually buy on the market, represents a stake in a corporation. Many companies choose to pay out a portion of profits to shareholders in the form of dividends. Some companies have a long history of issuing dividends at rising rates, but they're not guaranteed and a company can reduce or eliminate dividends at any time.
Stock Price Fluctuations and Risk
Aside from dividends, however, the share value of common stocks tends to rise and fall with market conditions and with the financial results of the underlying company. Dividend yields on common stocks are typically lower than the payouts available from bonds or preferred shares. And if the company's fortunes take a turn for the worse and its ability to pay dividends and interest weakens, bondholders and preferred stockholders will generally be paid first. Common stockholders, under such circumstances, may see their dividends cut or even eliminated.
Preferred shares are a special kind of stock that function a bit more like bonds. Preferred shares have a fixed dividend rate, which will not change unless the issuing company does not earn enough money to pay the dividend. Preferred shareholders are paid dividends before common stock shareholders.
Unlike bonds, preferred shares do not usually have a maturity date, and the return of principal is not guaranteed. Also, unlike common stocks, preferred stock shares do not carry voting rights. Preferred shares trade on the stock market like common shares, but unlike common shares prices are primarily determined by the dividend rate and by current interest rates for comparable risk securities.
They're often not influenced as much by the underlying company's growth or profit prospects. The dividend yield of some preferred issues from quality companies can be quite attractive to investors. That's because they tend to yield much higher rates than common shares.
Building an Income Portfolio
An investment portfolio designed to produce income can own all three types of income securities. Typically, bonds will make up the bulk of an income-oriented portfolio, providing steady income and stable principal values.
Dividend-paying common stocks offer the opportunity for a growing income stream and increased capital values. Preferred share investments can add some more interest income, particularly when the rate earned on preferred shares is significantly higher than the yields paid by bonds of comparable quality.