SIMILARITIES AND DIFFERENCES OF BONDS AND PREFERRED STOCKS

Bonds and preferred stocks are both investment vehicles. These two are some of the many methods a company use in raising capital. Bond is a debt instrument. Stock is an equity or ownership interest. There is less risk in holding bonds than owning stocks, but the latter gives higher return.

Aside from the above-mentioned characteristics of bonds and preferred stocks, what are their other similarities and differences?

Similarities

• Bonds and preferred stocks are sensitive to changes in interest rate. Prices of preferred stocks and bonds decline when interest rates increase since future cash flows are discounted at a higher rate and provide a better dividend yield. Conversely, prices climb when interest rates fall.
• Both instruments may have an embedded call option, making them callable, giving the issuer the right to call back the security if interest rates drop and issue new securities at a reduced rate. This won’t only confines the investor’s advantage, but also signals reinvestment risk.
• Both derivatives offer no voting rights in the firm.
• Both securities provide very limited range for capital appreciation because they have a set payment. Stockholders and bondholders do not gain from the company’s future growth.
• Both are convertible, enabling investors to change either security into a determined number of shares of the firm’s common stock. This feature allows them to partake in the company’s future growth.

Differences

• Although bonds and preferred stocks rank higher than common stock. But the former have more seniority than the latter in case of bankruptcy. Realistically speaking, interest payments on bonds are legal obligations and must be paid first before tax payments. On the other hand, dividends on preferred stocks are given after paying taxes, and are not made if the firm is going through financial difficulties. Any missed dividend payment may or may not be paid in the future depending on whether the preferred stock is cumulative or non-cumulative,
• Generally speaking, in the market, yields on preferred stocks are higher than bonds, compensating for the higher risk the preferred shares present to investors.
• Risk on preferred shares are two notches below bonds, considering the lower claim on the firm’s assets.
• Bonds have higher par value than preferred shares. But both are normally issued at par.