How they work
A preferred stock pays a fixed dividend with priority over any dividend payments made on common stock. This comes in addition to any potential increase in the price of the preferred shares you own. A convertible bond pays you interest like a normal bond, but also allows you to profit from an upturn in the value of a company, by converting the bond to common shares. A third alternative (but one which we won’t examine in detail here) is to trade bonds as CFDS, which enables short and medium term investors to go short on both equities and
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Similarities between preferred stocks and convertible bonds
- The market value of both instruments is affected by changes in interest rates. When interest rates go up, prices for these investments (both with fixed payments) go down. The effect is often less marked on preferred stock however.
- Both exist in “callable” versions. For instance, when a preferred stock’s fixed dividend is greater than prevailing interest rates, a company may “call” the preferred stock and pay the investor a pre-defined redemption price.
- Preferred stock has priority over common stock for any payments due, and so do bonds. However, bonds also have priority over preferred stock.
- Preferred stock can often be converted into common stock, like convertible bonds can be converted into common stock. In both cases, investors have a safety net of a minimum income while the opportunity remains open for investors to profit from an upturn in the overall worth of the issuing company.
- Credit ratings apply to preferred stocks as to bonds. Ratings are lower for preferred stocks, because they do not have the same guarantees as bonds.
- Current yields for preferred stock are calculated as for bonds. Example: with a fixed dividend of $1.80 and a market price of $30, a preferred stock has a current yield of 6% ($1.80/$30). As stock presents higher risk than bonds, the yield on preferred stock may be set higher than for convertible bonds issued by the same company.
Differences between preferred stocks and convertible bonds
- At the end of the day, preferred stock is still equity, while convertible bonds are still debt. In other words, a company is not obligated to pay the preferred stock holders a dividend. However, preferred stock holders must be paid all their dividends before common stock holder receive a dividend.
- Payments to investors holding preferred stocks cost the issuing company more per dollar paid out, but are also subject to board approval by the company. Bond interest is paid out before tax, making it less expensive, and is also an obligation that a company must respect.
- Preferred stock may be more accessible to investors than bonds, because they tend to have lower face values, compared to bonds with face values of around $1,000 and minimum purchase requirements.