The depth of the capital markets means there are many financial instruments out there to fit your investment objectives. Among these are preferred stock and convertible notes. Preferred stock and convertible notes are hybrid financial instruments. A preferred stock acts like a stock but also has qualities of a debt instrument. A convertible note, usually in the form of a bond, gives you the option to convert the bond into shares when you choose.
A preferred stock, like common stock, pays a dividend but has higher rank than common stock should a company face liquidation. Preferred stockholders also receive dividend payments before common shareholders in the case of liquidation. However, preferred stockholders stand behind bondholders who receive first claim of the company's assets in a liquidation. Preferred stocks are either perpetual, meaning they have no maturity date or have a long-term maturity date of 30 to 50 years. As of June 2012, the 30-day yield on the iShares S&P Preferred Stock Index Fund was about 6.25 percent. This compares to an average dividend yield of 3.26 percent on the S&P 500 going back to 1953 for the period ending May 2012.
A convertible bond has face value of $1,000 and a conversion ratio that tells you how many shares in exchange for the bond. For example, a conversion ratio of 50 means that you receive 20 shares for each bond you own ($1,000 divided by 50). Because conversion bonds offer an equity kicker, they sell at a premium to regular bonds. The equity kicker in the convertible bond is the equity incentive the company throws in to get you to accept a lower rate of interest compared to a regular bond. In exchange, you receive the option of converting the bond into stock.
Preferred Stocks vs. Convertible Bonds
While a preferred stock offers you the peace of mind of receiving a dividend, you don't receive any capital appreciation on the shares if the company does well. Only common stockholders receive the benefit of capital appreciation. The nice thing about a convertible bond is that it allows you to participate in capital appreciation of the company's stock. Obviously, if the stock is not doing well, there's no need to convert. In the meantime, you can still collect periodic interest payments from the bond. Typically, a bond pays interest semi-annually or twice a year to bondholders. For example, a bond with a $1,000 face value with an 8 percent coupon pays interest of $40 every six months (($1,000 x 8 percent)/ 2).
Before investing in either a preferred stock or convertible note, you should understand the credit quality of the issuer. Some companies issue preferred stocks because they already have a lot of debt on their balance sheet and others do so for regulatory reasons. Only a small portion of preferred stocks carry a rating of an investment grade rating of AAA/AA, which is the highest grade a company can receive. A company with a AAA/AA rating pays a lower interest rate because a credit rating agency deems the company to be financially sound. Companies that receive lower credit ratings pay higher interest rates, making their issuance of preferred stock or convertible bonds more expensive. Credit quality also applies to convertible bonds too. Whether a company issues preferred stock or convertible notes, it should be strong enough to withstand economic downturns.