The primary distinction between preferred stock and bonds is that preferred stock is an ownership stake in a company and bonds are interest-bearing loans to companies, agencies and governments. While they are similar in that they both offer an income stream to the investor, preferred stock and bonds differ in several important characteristics.
Preferred stock is a form of equity security. A corporation issues stock to raise capital by giving investors an ownership stake in the company proportionate to the amount of stock they own. Usually the stock offers a regular fixed payment in the form of a dividend. Preferred stock is often referred to as a “hybrid” security because it offers the regular fixed income of a bond but also the ownership stake in a company in the form of common stock.
A bond is a debt security. An entity such as a company, municipality, agency or government issues bonds to investors for a set time period, or term. The bondholder gives the issuer the face value of the bond in return for a promise to pay interest on the principal for a fixed rate at regular intervals. At the end of the term, when the bond reaches maturity, the issuer pays back the bondholder the full amount of the principal.
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Preferred stock has a fixed dividend payment, but a corporation can choose to skip the payment to preferred stockholders if the company is in financial trouble. Bond interest payments are backed by the force of law, which requires the issuer to pay or face bankruptcy. Because of this distinction, bonds offer a more reliable income stream than preferred stock.
Obligation to Pay
Debt obligations take precedence over all other obligations a company has. Before dividends are paid to either preferred or common stockholders, interest on bonds must be paid. In the event of bankruptcy, bondholders again take precedence, and are usually able to collect some percentage from the liquidation of the company’s assets. Shareholders may be left with little or no compensation. Bonds offer a more secure return on investment because of the seniority of debt obligations.
If a company fails to make a profit, preferred stockholders may see their dividends suspended. The value of the stock may fluctuate in value due to market risk. With bonds the primary risks are interest rate fluctuation and risk of default. An increase in interest rates makes a bond less valuable. A bond issuer may default if unable to meet its debt obligations. In this case the bondholder would not receive his interest due, although he may be able to recoup some of his losses from bankruptcy proceeds.
Preferred stock is often issued instead of bonds because it has a weaker obligation to pay. Both preferred stock and bonds can be “callable,” which means that the issuer has the option to buy them back under certain conditions. For the investor, both preferred stock and bonds may be “convertible,” which means that she has the option to convert them to common stock under preferable market conditions. U.S. Treasury and municipal bonds also have tax advantages that offer more flexibility to high-income investors. Both securities are liquid, or easily traded, in either the stock or bond markets.