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Difference Between Bonds and Preferred Shares

Preferred SharesMany corporations either use bonds or preferred shares for raising money. Both types of investments are similar in certain aspects however there are a few key differences that set them apart. The type of security they represent is one of the biggest. For example, if a shareholder invests in preferred shares, the stock will be considered as an equity instrument. This means that the shareholder will be entitled to a partial ownership of the company instead of a creditor. On the other hand, investing in a bond would mean that the shareholder is a creditor of the company.

As you can see, I have been sharing more information about the fixed income sector as I believe it is a necessary complement to dividend investing. Below are some related posts if you want to read further:

Payment – Interest or Dividends

Both convertible bond and preferred stock shareholders receive regular payments from the companies that they invest in. However, the method of payment differs in both cases. In the case of bonds, an investor would receive debt that is owed by a company. On the other hand, investors who settle for preferred stocks will receive regular dividend payments.

The dividends payment will in turn be based on a percentage of the preferred shares. Whatever the case may be both types of payments do guarantee regular payments.

Furthermore, bonds come with a definitive date of maturity. Once the date is reached for a bond to mature it is returned at face value to the investor by the company. Preferred shares does not require a maturity date which means that investments can last forever.

Advantages of Bonds

Convertible bonds, as an example, offer investors a chance to profit in a company that pays fixed rates of interest. Such an incentive would also allow investors to claim partial ownership of a company when they convert the bond to stock. In this case investors will not have to worry about stock fluctuations in the market.

An investor can also convert the bond to common stock if the company profits and sees a significant rise in its common shares. Bondholders will also be paid first if a company suffers financially or faces bankruptcy.

Disadvantages of Bonds

Most disadvantages of convertibles bonds, as an example, are the same as using general debt. For example, dealing with bonds means that corporations herald a risk of bankruptcy as compared to preferred shares. Also, investors who finance with convertible securities might risk diluting the EPS of a company’s common stock as well as risking ownership or control.

Furthermore, a heavy use of debt might also render a company unable to finance operations on a regular basis especially in times of economic stress. Larger companies might not be affected by such an issue but the same cannot be said for companies that have just started out. Such companies will eventually face difficulties in raising the necessary capital to stay in business.

Advantages of Preferred Shares

Investors usually forgo bonds in favor of preferred stock since the latter promises higher yields. In this way, preferred stock would increase financial leverage. The preferred dividend will be a fixed obligation which gives investors the advantage of knowing what the yield will be. Also, the dividends from preferred stock can be put on hold if the company’s earnings are uncertain or insufficient. This makes preferred stock a flexible source of financing.

Disadvantages of Preferred Shares

A preferred share can have a maturity that lasts as long as twenty years while others do not have any at all. Issuers are also allowed to call in shares in most cases. This means that an issuer may decide to buy back an existing preferred share in favor of issuing new ones at lower rates.

Furthermore while offering fixed dividends might have almost no effect on a preferred share price, the preferred share dividend could still be threatened if the company’s profits decline. This could also hurt its share price.

Readers: How do you see bonds and preferred shares fit in your portfolio?

Image courtesy of David Castillo / FreeDigitalPhotos.net

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