Preferred Stock Vs. Bonds

Preferred shares and bonds are similar but not identical investments.

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Preferred stock is a special type of ownership stake offered by some companies that also issue common stock. When you purchase a bond, by contrast, you are loaning money to the issuer. Although the market behavior of these two financial products is similar at times, they each carry a distinct set of risks and benefits.

How Preferred Stock Works

Preferred stockholders receive preference over common stockholders in the distribution of dividends. In fact, they are typically entitled to guaranteed periodic dividend payments. If the corporation goes bankrupt and dissolves, preferred stockholders also receive preference over common shareholders in the distribution of corporate assets. Unlike common stockholders, however, preferred shareholders have no voting rights. Some companies issue preferred stock that is convertible to common stock.

How Bonds Work

Like preferred shareholders, bondholders do not enjoy voting rights. Since bonds do not confer an ownership stake in the issuer, bondholders are not entitled to dividends either. Instead, a bondholder receives interest payments at regular intervals until the loan matures, at which point he receives a lump sum repayment of the original purchase price. Corporations commonly issue bonds, but so do governments at the local, state and federal level. Bondholders enjoy the same legal right to receive interest payments that any other creditor does.

Income Risks

Preferred shareholders do not enjoy an absolute right to receive dividends -- the issuing corporation is entitled to suspend dividend payments as long as it is insolvent. Bondholders, by contrast, enjoy a right to receive interest payments that is superior to a preferred shareholder's right to receive dividends -- an issuer that refuses to pay bond interest can be forced into bankruptcy. If a corporation issues both preferred stock and bonds, it must pay bondholders before preferred shareholders in the event of bankruptcy and dissolution. Despite this priority, however, bondholders must compete with other external creditors for a piece of the corporation's remaining assets. One advantage of investing in bonds is that governments issue bonds. Since governments can tax their citizens, they seldom default on their bond obligations, making these investment safer than purchasing stock in a privately owned corporation.

Price Volatility

Since both preferred stocks and bonds can be publicly traded, their prices fluctuate over time. Typically, bond prices are more stable than stock prices, although preferred stock prices are usually more stable than common stock prices. If preferred stock is convertible to common stock, its price volatility may approach that of common stocks. This reality is a double-edged sword -- you can lose money more quickly holding a volatile financial product, but you can make money more quickly as well.