When you buy a bond, you become a creditor of the bond issuer; when you buy a preferred redeemable stock, you become a part owner of the corporation that issued the stock. While both bonds and preferred stocks can provide you with income, you should familiarize yourself with the potential risks and the rewards before you invest in either of these securities.
Companies raise money to cover short-term expenses by issuing both preferred stock and bonds. Bondholders receive interest payments, while stockholders receive dividends. When you buy a redeemable stock, the corporation that issues it has the right to buy back the stock for a set price. Companies cannot typically buy back or redeem stock within a certain number of years of the issue date. Firms often buy back stock if interest rates drop, as it becomes cheaper to pay interest on borrowed money than to keep paying dividends on stock. Therefore, a holder of redeemable preferred stock takes the risk of the issuer redeeming the stock. Some bonds are callable, which means the bond issuer can pay off the debt at any time, but many bonds do not have this call risk: holders receive income for the entire bond term.
Because bondholders are creditors while stockholders are owners, stockholders have more to lose in the event of a liquidation or bankruptcy reorganization of the corporation. In a liquidation or reorganization, there is often insufficient money to pay the claims of all creditors and owners. What money there is first goes to pay priority liabilities like staff wages and taxes. After settling these claims and any secured claims, unsecured claims such as those of bondholders are next. Preferred redeemable stockholders can only make claims on the company's assets after creditors, including bondholders, have been paid. Preferred stockholders' claims are addressed ahead of the claims of common stockholders, but in many instances, bondholders get back some of their investment, while stockholders lose everything.
Since preferred stocks expose investors to a higher level of principal risk than bonds, investors need some kind of an incentive to invest in these stocks. That incentive comes in the form of high yields. You typically earn more in the form of preferred stock dividends than you earn in terms of interest payments on bonds. However, some high-risk bonds may have higher yields than top-quality preferred stocks, so make sure you understand the risks if you find a bond with an unusually high yield.
You have to pay ordinary income tax on interest payments from bonds. If you fall into the highest tax bracket, that could mean losing 35 percent of your yield to federal tax before you even take into account possible state income tax. Many redeemable preferred stocks pay what the Internal Revenue Service refers to as "qualified dividends," which means you pay the qualified dividend tax of between 5 and 15 percent on your earnings. This tax treatment makes preferred stocks an attractive alternative to taxable corporate or federal bonds. However, you can avoid paying taxes altogether if you invest in municipal bonds, since most of these securities are exempt from federal income tax. Furthermore, you pay no state income tax on interest payments on municipal bonds that were issued by entities based in your state.
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