In What Ways Is Preferred Stock Like Long-Term Debt?

by Mike Parker, Demand Media
    Preferred stocks are a hybrid investment, with qualities of both stocks and bonds.

    Preferred stocks are a hybrid investment, with qualities of both stocks and bonds.

    Stashing money in your local bank savings account is a good idea. It helps to have some readily available funds to handle minor emergencies, like when your washing machine dies. Interest rates on savings accounts aren't particularly attractive, so you might look in other areas for your investment dollars. You can choose between equities, like stocks, or debt instruments, like long-term bonds, or you might consider preferred stocks, which have characteristics of both types of investments.

    Preferred vs. Common

    If you own stock, chances are it is common stock. Common stock, as the name implies, is the most common class of stock. Each share of common stock represents an equal amount of ownership in the company and gives you the right to participate in the company's fortunes, whether good or bad. You get to cast one vote for each share of common stock you own at the annual shareholder's meeting. If the company goes bankrupt, the common stockholders are the last ones with a claim on company assets. Preferred stock also gives you ownership in the company, but as the name implies, you also get some preferential treatment. The company must pay all dividends owed to preferred stockholders before any dividends are paid to common stockholders, and in the event of a bankruptcy, preferred stockholders come before common stockholders in the pecking order for the company's assets

    Long-Term Debt

    Long-term debt is any debt with a maturity date of more than 12 months. For example, U.S. Treasury Notes are long-term debt securities because they are issued with a maturity of not less than one year. U.S. Treasury Bills mature in one year or less, so they are short-term debt securities. Preferred stocks resemble long-term debt because they typically have a maturity of at least 30 years, or they have no stated maturity at all, according to the CBS MoneyWatch website.

    Similarities

    Both long-term debt securities and preferred stocks can provide you with a steady stream of regular income. Debt securities pay interest, while preferred stock pays dividends. The market value of both long-term debt securities and preferred stocks are interest-rate sensitive. If prevailing interest rates rise, the value of debt securities and preferred stocks tend to drop. If prevailing rates drop, their value tends to increase.

    Differences

    Long-term debt securities and preferred stocks have a lot in common, but they have some striking differences too. If an issuer fails to make an interest payment on a bond, it is in default and you have some legal recourse. A company can suspend preferred-stock dividends without defaulting. Dividends from preferred stock are fully taxable as ordinary income, while the interest on some long-term debt has tax advantages. For example, the interest on U.S. Treasury bonds is free from state income taxes, and the interest on municipal bonds is usually free from federal income taxes.

    Caveat Emptor

    The credit rating on a company's preferred stock is usually lower than the same company's bonds and common stock, so while you might get a higher payout, you are also taking a greater risk. Some preferred stocks come with a call provision, which gives the company the right to buy the stock back whenever it chooses. That doesn't mean much if prevailing interest rates rise, but if rates fall the company might choose to call your preferred stock. You run the risk of your preferred stock losing value if interest rates increase, but you don't get the benefit of locking in long-term high interest rates if prevailing rates fall.

    About the Author

    Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.

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