By Ashley Camp
There are many ways a business can fund its operation. These alternatives include public floating of shares, bank borrowing, franchising, government assistance, corporate bonds, and venture capital. In this article, we’ll explore the differences and similarities between preferred stocks and corporate bonds to enable you to decide on a favorable option that meets your needs. So keep reading.
Investors have two main choices when investing in stocks: preferred or common stock. By buying the common stock of a company, you become a shareholder, earn a dividend and get voting rights in the decision-making processes. On the other hand, if you buy preferred stocks, you don’t get voting rights; however, you’re the first to receive dividends before the common stockholders.
Banks, insurance firms and utility companies usually issue preferred stock. However, the market is relatively small because only a small percentage of publicly-traded corporations issue these shares, the market is relatively small.
Sometimes a preferred stock can be converted into common stock, and shareholders may have voting rights. In this case, they are hybrid stocks because they contain debt and equity elements. Preference shares are issued at par value and are redeemable at a later date at a fixed price. Generally, they provide higher returns than bonds.
Cumulative and non-cumulative preferred stocks
An important aspect of preferred stock is whether dividends are cumulative or not. If they are cumulative, unpaid dividends are set in a nominal account and are paid before ordinary common stock. Additionally, they must be paid in full to the preferred shareholders.
By contrast, if they are non-cumulative and dividends are missed, the preferred stockholder will not receive them in the future.
The rights of preferred shareholders are;
- Right to company ownership by purchasing preferred stock at the stock market
- The right to get dividends before the common shareholders
- Right to receive fixed dividends at regular intervals even when the company is making losses. The dividend payout ratio is usually fixed, which can be a disadvantage if the company makes huge profits.
- The right to preferential treatment after liquidation. During winding up, preference shareholders have priority in the payment of dividends. However, they’re not paid first because the company must pay creditors before the shareholders.
- Right to arrears if no dividends are paid in the previous year for cumulative dividends.
Corporate bonds are debt securities issued by companies to raise funds. Their collateral comes from the company’s ability to pay, physical assets, and creditworthiness. Unlike stocks, bond investors have no voting rights or equity in the company.
Like other investments, corporate bonds have risks. For example, one significant risk to an investor is that the company may delay paying the principal or interest. In addition, default risk is crucial to investors because the company cannot pay its obligations.
Corporate bonds constitute the largest components of the bond market in the U.S. Other types include municipal bonds, treasury bonds, and government bonds. Companies float bonds to buy new equipment, pay dividends, finance mergers, buy back stock and invest in research and development.
There are different categories of bonds, including;
- Short-term and long-term corporate bond
Bonds are classified depending on the maturity period or when the issuing company pays back the principal. Usually, short-term bonds last less than three years, medium-term four to ten years, and long-term bonds more than ten years. Long-term corporate bonds have higher interest rates but could be risky.
Additionally, bonds are classified based on their creditworthiness. Typically, credit rating companies assign scores according to risk evaluation and default risk. However, they review the scores periodically and adjust the ratings if conditions improve.
- Investment grade and non-investment grade bonds
Depending on the credit scores, bonds are also classified as investment or non-investment grades. Whereas investment-grade bonds are generally paid on time, non-investment grades are speculative and high-yield. They also have high-interest rates that compensate you for high risk.
- Fixed-rate, floating bonds, and zero-coupon bonds
Corporate bonds vary depending on the type of interest payable to investors. However, most bonds pay a fixed interest throughout the bond’s tenure. These interest payments are known as coupon payments, while the interest rate is the coupon rate.
Floating rate bonds have their interest rates reset after a certain period, usually six months. Their rates track a bond index or a specific referent.
Zero-coupon bonds have no coupon payments and, therefore, no interest payments. However, you can get a single payment upon maturity, which is higher than the purchase price.
Choosing between Preferred Stocks and Bonds
When choosing between preferred stocks and bonds, ensure the issuing company is reputable and has a healthy balance sheet. So ensure you review at least five years of the company’s earnings reports before investing your money. Other things to consider include risk, yield, par value, and capital appreciation.
In liquidation, bondholders may claim the company’s assets, but priority depends on whether the bond is secured. If there’s an existing collateral, you may have a legal right on the security to satisfy your claim.
Unsecured bonds, also known as debentures, have a general claim against the company’s cash flows and assets. The compensation process is complex because other stakeholders, such as banks, customers, and suppliers, may have a claim on the company’s assets.
Owning a preferred stock allows investors to enjoy a fixed dividend irrespective of whether the company profits. Also, because preferred stocks have some similar features to bonds and shares, they can enable investors to have a diversified pool of investments and strengthen their fixed-income portfolio.
Are Preferred Stocks Low-Risk Options Than Corporate Bonds?
Ideally, any investor wants to be tolerant and patient in their investment journey to reap long-term returns. However, if you are risk-averse, you would prefer staking your money on a low-risk investment.
It’s important to note that preferred stocks can be at high risk if a company goes bankrupt and there are no underlying assets to pay investors. Take a case study of the iShares Preferred and Income Securities ETF, whose ticker is PFF. This investment option has both characteristics of stocks (by representing ownership in a company) and bonds since it pays a fixed dividend.
Looking at the ETF’s performance over the years, you can notice the 2008 slump when the price drastically fell to an all-time low of $15.05. As you probably know, the stock market crash of 2008 was the biggest drop in history, leading to a dramatic decline in the prices of stocks across the market.
The financial crisis affected many investments, including stocks, ETFs, and bonds. Therefore, preferred stocks are not an exception and can be affected by market forces.
From an investor’s point of view, preferred stocks offer you an opportunity to build a diversified portfolio with a decent yield in a low-interest rate environment. Besides stocks and bonds, other investment vehicles can build your wealth over the long term, including real estate, mutual funds, exchange-traded funds, and life insurance. However, it’s essential to read the fine print for life insurance because a renewable term explained clause might state that it doesn’t have a cash value or last for life.
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