Bonds and Preferred Stocks: Similarities
Interest Rate Sensitivity
Preferreds are issued with a fixed par value and pay dividends based on a percentage of that par at a fixed rate. Just like bonds, which also make fixed payments, the market value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the value of the preferred shares would need to fall to offer investors a better rate. If rates fall, the opposite would hold true. However, the relative move of preferred yields is usually less dramatic than that of bonds.
Preferreds technically have an unlimited life because they have no fixed maturity date, but they may be called by the issuer after a certain date. The motivation for the redemption is generally the same as for bonds; a company calls securities that pay higher rates than what the market is currently offering. Also, as is the case with bonds, the redemption price may be at a premium to par to enhance the preferred's initial marketability.
Like bonds, preferreds are senior to common stock. However, bonds have more seniority than preferreds. The seniority of preferreds applies to both the distribution of corporate earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With preferreds, the investor is standing closer to the front of the line for payment than common shareholders, although not by much.
As with convertible bonds, preferreds can often be converted into the common stock of the issuing company. This feature gives investors flexibility, allowing them to lock in the fixed return from the preferred dividends and, potentially, to participate in the capital appreciation of the common stock.
Like bonds, preferred stocks are rated by the major credit rating companies, such as Standard & Poor's and Moody's. The rating for preferreds is generally one or two tiers below that of the same company's bonds because preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.
In our next blog post, we will discuss the differences between preferred stocks and bonds.