The main reason to treat preferred stock as debt rather than equity is that it acts more like a bond than a stock, and investors buy it for current income, not capital appreciation. Like common stock, preferred stock represents an equity stake in a company, but its many features make it more like a debt security.
Limited Upside Potential
Both preferred stocks and bonds have limited upside potential. Bonds have maturity dates when the principal is repaid in full. The closer a bond gets to maturity, the closer it trades to its face value, or the amount to be repaid at maturity. Preferred stocks have call provisions, which is the ability of the issuer to call, or redeem, them at a predetermined value after a certain date. As a preferred stock gets closer to the call date, investors become reluctant to pay more for it than what it can be called for.
Both preferred stock dividends and bond interest are typically fixed for the life of the security. Dividend yields on preferred stocks are usually similar to interest yields on comparable bonds. Investors buy bonds and preferred stocks for current income.
Interest Rate Sensitivity
Both preferred stocks and bonds are interest rate sensitive: When interest rates go up, both go down in price, and vice versa.
Safety of Principal
Preferred stocks and bonds are considered safer than common stocks. If a company goes into bankruptcy liquidation, its assets are sold to pay off the investors. Bondholders are paid ahead of stockholders, but preferred stockholders are paid ahead of common stockholders. The safety of both bonds and preferred stock depends on the issuer’s credit rating. Credit rating reflects a company’s ability to pay its obligations, be it bond interest or preferred stock dividends. When an issuer’s credit rating is changed, it affects the price of both its bonds and preferred stocks.
Preferred Stock Vs. Bond Risk
Preferred stocks are riskier than bonds. If a company misses a bond interest payment, the bondholders can force it into bankruptcy to get their money back, but the company can cut or suspend dividends on preferred stock at any time with no recourse for investors. When a bond matures, it must be paid off in full, but a preferred stock call date is a right, not an obligation -- a company can choose not to call a preferred stock if it is to its advantage. For example, when interest rates are high, a company has no reason to call a low-yielding preferred stock if it then has to borrow at higher rates.
Video of the Day
- The Boston Institute of Finance Stockbroker Course: Series 7 and 63