Preferred Stock vs. Bonds

Definition

Preferred stock and bonds are both financial instruments that companies use to raise capital, but they differ in ownership and rights. Preferred stock represents ownership in a company with a fixed dividend payment, while bonds are debt instruments that require repayment of principal and interest. Investors choose between these two based on their risk tolerance and the desire for income, as preferred stock typically offers higher dividends but less security than bonds.

5 Must Know Facts For Your Next Test

1. Preferred stockholders have a higher claim on assets than common stockholders but rank below bondholders in case of liquidation.
2. Preferred dividends are generally fixed and must be paid before any dividends can be issued to common stockholders.
3. Bonds typically have a defined maturity date when the principal amount is repaid, while preferred stocks do not have a maturity date.
4. In terms of volatility, bonds tend to be less risky than preferred stocks, making them more appealing to conservative investors.
5. The market price of preferred stocks can be more sensitive to interest rate changes compared to bonds, affecting their yields.

Review Questions

• Compare and contrast the rights and claims of preferred stockholders versus bondholders.
  • Preferred stockholders have rights related to dividends and claim priority over common shareholders during asset distribution, but they rank below bondholders when it comes to liquidation. Bondholders, being creditors, have a legal right to receive interest payments and principal repayment. This difference in hierarchy affects how investors perceive risk; bondholders enjoy more security due to their superior claim on assets.
• Evaluate the implications of fixed dividends on preferred stocks compared to the fixed interest payments on bonds regarding investor returns.
  • Fixed dividends on preferred stocks provide a stable income stream but do not guarantee payment if the company faces financial difficulties, unlike fixed interest payments on bonds, which are legally binding. This distinction means that while preferred stock may offer higher potential returns during profitable periods, it also carries greater risk if the company does not perform well financially. Investors need to weigh these factors when deciding between preferred stocks and bonds.
• Analyze how changing interest rates affect the market value of preferred stocks compared to bonds and what this means for investors in each instrument.
  • As interest rates rise, the market value of both preferred stocks and bonds typically declines; however, preferred stocks often exhibit greater sensitivity due to their fixed dividend structure. For investors, this means that while bonds may provide more stability in a rising rate environment, preferred stocks might experience sharper declines in value. Understanding this dynamic helps investors manage their portfolios effectively during varying economic conditions.

Related terms

Dividend: A payment made by a corporation to its shareholders, usually derived from profits, which is a primary feature of preferred stock.

Coupon Rate: The interest rate that a bond issuer pays to bondholders, typically expressed as a percentage of the bond's face value.

Liquidation Preference: The order in which creditors and investors are paid in the event of a company's liquidation, which typically favors bondholders over preferred stockholders.