Corporate bonds and preferred stocks are two of the most common ways for a company to raise capital. Income-seeking investors can make good use of either: The bonds make regular interest payments, and the preferreds pay fixed dividends. But it's important to be aware of the similarities and differences between these two types of securities.

Similarities

1. Interest rate sensitivity

Both bond and preferred stock prices fall when interest rates rise. Why? Because their future cash flows are discounted at a higher rate, offering a better dividend yield. The opposite happens when interest rates fall.

2. Callability

Both securities may have an embedded call option (making them "callable") that gives the issuer the right to call back the security in case of a fall in interest rates and issue fresh securities at a lower rate. This not only caps the investor’s upside potential but also poses the problem of reinvestment risk. (For more, see: "Callable Bonds: Leading a Double Life.")

3. Voting rights

Neither security offers the holder voting rights in the company.

4. Capital appreciation

There is very limited scope for capital appreciation for these instruments because they have a fixed payment that does not benefit them from the firm’s future growth.

5. Convertibility

Both securities may offer this option, which allows investors to convert the bonds or preferreds into a fixed number of shares of the common stock of the company, which allows them to participate in the firm’s future growth.

Differences

1. Seniority

In case of liquidation proceedings – a company going bankrupt and being forced to close – both bonds and preferred stocks are senior to common stock; that means investors holding them rank higher on the creditor repayment list than common-stock shareholders do. But bonds take precedence over preferred stocks: Interest payments on bonds are legal obligations and are payable before taxes, while dividends on preferred stocks are after-tax payments and need not be made if the company is facing financial difficulties. Any missed dividend payment may or may not be payable in the future depending on whether the security is cumulative or non-cumulative.

2. Risk

Generally, preferred stocks are rated two notches below bonds; this lower rating, which means higher risk, reflects their lower claim on the assets of the company.

3. Yield

Preferred stocks have a higher yield than bonds to compensate for the higher risk.

4. Par value

Both securities are usually issued at par. Preferred stocks generally have a lower par value than bonds, thereby requiring a lower investment.

Advantages of Preferred's

Institutional investors like preferred stocks due to the preferential tax treatment the dividends receive (70% of the dividend income can be excluded on corporate tax returns). This may suppress yields, which is a negative for individual investors.

The very fact that companies are raising capital through preferred stocks could signal that the company is loaded with debt, which may also pose legal limitations on the amount of additional debt it can raise. Companies in the financial and utilities sectors mostly issue preferred stocks.

The Bottom Line

The high yield of preferred stocks is definitely a positive, and in today’s low interest rate environment they can definitely add value to a portfolio. Adequate research needs to be done about the financial position of the company, however, or investors may suffer losses.

Another option is to invest in a mutual fund that invests in preferred stocks of various companies. This gives the dual benefit of a high dividend yield and risk diversification.

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