Preferred Stocks and Bonds: Differences
Type of Security
Preferred stocks are equity; bonds are debt. Most debt instruments, along with most creditors, are senior to any equity.
Preferreds pay dividends. These are fixed dividends, normally for the life of the stock, but they must be declared by the company's board of directors. As such, there is not the same array of guarantees that are afforded to bondholders. This is because bonds are issued with the protection of an indenture. With preferreds, if a company has a cash problem, the board of directors can decide to withhold preferred dividends; the trust indenture prevents companies from taking the same action on bonds. Another difference is that preferred dividends are paid from the company's after-tax profits, while bond interest is paid before taxes. This factor makes it more expensive for the issuing company to issue and pay dividends on preferred stocks.
Computing current yields on preferreds is similar to performing the same calculation on bonds: the annual dividend is divided by the price. For example, if a preferred stock is paying an annualized dividend of $1.75 and is currently trading in the market at $25, the current yield is: $1.75/$25 = 7%. In the market, however, yields on preferreds are typically higher than those of bonds from the same issuer, reflecting the higher risk the preferreds present for investors.
While preferreds are interest rate sensitive, they are not as price sensitive to interest rate fluctuations as bonds. However, their prices do reflect the general market factors that affect their issuers to a greater degree than the same issuer's bonds.
Accessibility for the Average Investor
Information about a company's preferred shares is easier to access than information about the company's bonds, making preferreds, in a general sense, easier to trade (and perhaps more liquid). The low par values of the preferred shares also make investing easier, because bonds, with par values around $1,000, often have minimum purchase amounts (i.e. five bonds).
In our next blog post, we will discuss the similarities and differences between Preferred Stocks and Stocks.