Preferred stock shares characteristics of both stocks and bonds, so they are a bit of a unique investment choice. Which is right for you depends on your investment objectives. If you're looking for current income, bonds can also help you meet that goal. When you understand the similarities and differences, you can determine which is best for you.
Preferred Stock Basics
Preferred stock is a class of shares in a corporation that gives its investors preference over holders of common stock, but the shareholders have no voting rights. Common stock holders may or may not receive dividend payments depending on whether or not the company makes a profit. Preferred shares are really a stock-bond hybrid. They pay a fixed dividend. Although preferred shareholders have priority in dividend distribution, if the company is not financially solvent the payments are suspended. If the corporation's assets are liquidated, preferred stock holders get dibs on a share of the remaining assets ahead of common shareholders.
Corporate Bond Basics
When you own stock you own a piece of that company. Bonds are different because you own a piece of a loan to a company. You are not a shareholder with voting rights, nor will you share profits. Instead you receive periodic interest payments, called coupons, until maturity. When the loan matures, you receive your principal payment back. Their prices fluctuate with market highs and lows as well. If a company goes bankrupt bondholders do get repaid before stockholders, but there is no guarantee of repayment. However, bonds do have risks. Agencies like Moody's and Standard & Poor's rate corporate bonds on their creditworthiness, and you can choose to stick to highly-rated bonds.
Government Bond Basics
Government bonds, like treasuries and municipals, are a different breed of investment. They are also loans that pay periodic interest, but their interest rates are generally lower than those of corporate bonds. Government bonds, however, bring tax advantages in exchange for their lower rates. The earnings on most government bonds are tax free, and they are considered to be a safe investment with a low risk of default.
Preferred stock tends to trade more like a bond than a stock, and prices can be more stable than common stocks. They might be more stable, but preferred prices can still take a much harder tumble than bonds. Another downside is that, like bonds, they don't have as much potential for capital gains as common stocks. If you're looking for income through dividends, look at bonds or preferred stock. If you're looking for long-term growth potential, you're better off with common stocks since growth is not the primary objective of preferred stock.
Ownership Through Funds
You can own individual bonds just like you can own individual stocks. Both carry commissions and transaction feeds. Many investors prefer the diversification and lower costs that come with owning mutual funds and exchange-traded funds (ETFs). Funds are cost-effective and leave the individual stock and bond picking to professional fund managers. You have a choice of hundreds of different bond funds. Mutual funds and ETF investing in preferred stock are a bit trickier. Most are closed-end funds that do not welcome new investors.
Annabella Gualdoni has written newsletters and reports for corporations and nonprofits since 1994. She is a real estate professional and also teaches subjects including international cooking and travel, dating/relationships and personal finance. Gualdoni has a Bachelor of Arts in international development from University of California, Berkeley, a Master of Arts in international relations from Boston University, and a Juris Doctor from Boston College Law School.