How Is Preferred Stock Like Long-Term Debt?

by W D Adkins

Corporations use several strategies to raise money. One method is to borrow money by issuing long-term bonds. As long-term debt securities, bonds are popular with investors who want to earn current income. Preferred stock is an alternative to corporate bonds. Charles Schwab says preferred stock is a hybrid with characteristics of both common stock and corporate bonds.

Definitions

Preferred shares of stock are similar to common stock in that both represent ownership of a corporation, although preferred stock shareholders usually don’t have voting rights at shareholders’ meetings. A major difference between preferred shares and bonds is that companies don’t have to pay back the money raised by selling preferred shares. Bonds are long-term debt with maturities up to 30 years. When the maturity date arrives, the corporation must redeem the bonds by repaying the borrowed money.

Fixed Income

Unlike common stock, preferred shares and bonds provide fixed annual payments. For bonds, the payments are in the form of a fixed amount of interest, called the coupon rate. Preferred shares pay a fixed dividend that is stated as a percentage of the share’s par value when it is issued. Corporate bond interest must be paid when it comes due. Failure to pay the interest puts a company in default. Dividends on preferred stock have to be paid if at all possible. However, a company can skip or delay preferred stock dividends when funds aren’t available. Many preferred stock issues are cumulative, meaning that a missed dividend must be made up at a later date.

Priority

Bondholders are creditors, so a company must pay interest due on bonds before any dividends are paid to owners of common or preferred stock. However, preferred stock is like long term debt because dividends on preferred shares, including any accumulated missed dividends, must be paid before any dividends can be paid on common shares. Should a company become insolvent, creditors such as bond owners have first claim on the firm’s assets. However, once creditors are paid, preferred stock shareholders must be paid off before any assets are distributed to common stock owners.

Benefits

Preferred stock and long-term debt like corporate bonds carry less risk for investors because owners of these securities are paid first if a company fails. Both types of security provide good income in the form of fixed periodic cash payments. The market behavior of preferred shares resembles that of bonds, which is a plus for buyers seeking low-risk investments. Prices for preferred shares are less volatile than for common stock. Since investors buy preferred shares for their income potential, the price of a preferred stock tends to vary with changes in market interest rates much like bond prices do.

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