How Is Preferred Stock Similar to Bonds?

by Vicki A. Benge

Economists state that preferred stock shares are as much like bonds as like common stock shares. The reason for this comparison is that both preferred stock and bonds have a number of similarities. For example, both types of certificates are rated by the major credit agencies and both preferred stocks and corporate bonds retain seniority over common stock in the event the company liquidates. In addition, the two have several other features in common that make the investments attractive to investors.

Value

Preferred stock and bonds are similar in that both have a par value. Both have a potential to increase in market value over time, but neither preferred stock nor bonds increase much in comparison to common stock shares. Both preferred stock and bonds produce earnings. Both earn fixed payments. Bonds earn interest and preferred stocks earn dividends. However, the interest payments due on bonds are part of the initial contract. Dividends on preferred stocks can be withheld at the discretion of management, but are generally not due to the negative credit outlook this imposes on the company.

Callable

Both preferred stock shares and bonds may have a call provision. When bonds or preferred stocks are said to be callable, this means the issuer can force the shareholder or bondholder to redeem the certificate. In stock or bond certificates with the call feature, the first eligible date the certificates can be called will be set at the time of issue, after which the issuer can exercise this provision. A company may call a bond issue when market interest rates fall to take advantage of issuing new debt at lower rates.

Interest Rates

Interest rates affect both preferred stocks and bonds, bonds more so than preferred stock. For example, when interest rates rise, bond prices decline and when interest rate decline, bond prices rise. The effect is not as predictable with preferred stock, as it generally depends on the reason interest rates have changed whether the effect on preferred stock is negative or positive.

Convertible

Both preferred stock and corporate bonds can be convertible, meaning the certificates include an option to be converted to shares of common stock. Generally, the price at which preferred stock can be converted to shares of common stock is set when the preferreds are issued. Some bond indentures, the contract that accompanies the issue, contain a provision allowing the bondholder to convert the certificate to a set number of shares of the company's common stock. This convertible feature on bonds is generally set so that the company's stock price must increase significantly before the bondholder would wish to convert.

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