Bonds and preferred stock are closely related. Both offer steady income in the form of periodic interest or dividend payments. Common stock dividends are optional. Of the three, only common stock prices can buck rising or falling interest rates trends. The issuer won't return your initial investment on any of these securities unless it calls them.
The unusual feature of a perpetual bond is that it has no maturity date. The price of a perpetual bond is the present value of its interest payments with no end date. Because the issuer need not redeem the bond, you can recover your original investment only by selling the security. However, if the bond is callable, the issuer can forcibly redeem it for a set amount. Some callable perpetual bonds have a “step up” feature, in which the issuer increases the interest rate after a set period. This feature encourages the issuer to call the bond. Like any fixed-rate bond, a perpetual bond’s price moves in the opposite direction to interest rate trends. Under international accounting standards, callable perpetual bonds are classified as equity.
Preferred stock always pays a dividend, which is normally fixed. The fixed payouts of bonds and preferred stocks means that these securities don't benefit from the growth of the issuing corporation. Preferred stock is normally perpetual, but some issues come with a maturity date or a call feature. A corporation must pay its preferred stock dividends before paying dividends on common stock. A missed dividend doesn't cause a corporate default, whereas a missed bond payout can force the issuer into liquidation. If a corporation is liquidated, proceeds first go to bondholders and then to holders of preferred stock. Common stockholders pull up the rear and often come away empty-handed. Some preferred stock issues contain conversion or put features that allow the holder to exchange the preferred stock for common stock or sell it back to the issuer.
Common stock normally has voting rights, which means the largest shareholders can control the corporation. Dividends are optional and can change at any time. The price of a common stock is some multiple of the corporation’s earnings per share. This means that higher earnings can cause common stock prices to rise, although the price/earnings ratio may expand or contract because of general economic conditions. It also means that stock prices and interest rates can move in the same direction. Inflation hurts preferred stock and bonds because it reduces the value of the payout. Moderate inflation can boost stock prices if it is accompanied by economic growth. Common stock is normally not callable.
In the United States, the payouts from bonds, including perpetual ones, are treated as interest and are taxable as ordinary income. Stock dividends normally qualify for long-term capital gains tax rates, which, as of 2013, vary from 20 percent to 0 percent, depending on your gross income. Bonds and stocks can provide capital gains or losses when you sell them. To get the benefit of the long-term capital gains rates, you must hold the security for more than one year. Otherwise, gains are taxed at your marginal tax rate.
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