As ways of raising money, bonds are usually considered a better proposition than preferred stock. They have limited life, and the interest they pay is lower than dividend payments. On the other hand, money raised through preferred stock is equity and as such does not show as debt on company’s books. This is important for the company’s future credit rating. Also, preferred stock can be more attractive for companies with cash problems, because it doesn’t come with the same obligations to future payments that bonds do.
Debt or Equity
While bonds are debt, preferred stock is equity. This means that bonds appear as debt on a company’s books. With preferred stock that is not the case, which makes it a better way of raising money for companies concerned about their credit rating. This is because a lower credit rating means higher cost of borrowing.
The difference between debt and equity has important tax implications for issuing companies. A company can claim tax deductions against interest paid on bonds, but not on dividends paid on preferred stock. That is because dividends, on both common or preferred stock, are paid from a company’s after-tax profit. One way for a company to make tax savings against dividends paid on preferred stock is to issue the stock through a previously established a trust. Sometimes, preferred stock can be easier to sell than bonds because institutional -- but not individual -- U.S. investors are entitled to tax-savings when they buy preferred stock.
Holders of both preferred stock and bonds receive fixed payments periodically. Most preferred stocks pay dividends quarterly, while bonds pay interest semiannually. When deciding whether to raise money through bonds or preferred stock, companies need to think about their future obligations. Preferred stock offers more flexibility, because companies with cash problems can simply suspend dividend payments and, depending on the type of preferred stock issued, pay it back in arrears later or simply forfeit it. With bonds, they can not do that without going into default.
On the other hand, paying dividends is usually more expensive then paying interest on bonds, because the former comes from profits, while the latter is a before-tax expense. Also, because preferred stock comes with a lower credit rating than bonds, yields on “preferreds” are usually higher than those on bonds.
Bonds may have an advantage over preferred stock because their life is limited and a company’s obligation to pay interest ends when the bond matures. Preferred stock does not have fixed maturity date and, therefore, a company’s obligation to pay dividends may be unlimited. Of course, both bonds and preferred stock may be callable, giving the issuing company the right to buy them back. Usually, when a company decides to do that, it has to pay higher rates than what the market is currently offering.
If they are convertible, both bonds and preferred stock can be converted into common stock of the issuing company. This can be attractive both for the company and for the investors. In case of bonds, the company may save money and improve its credit ratings by turning debt into equity, or -- in case of stock -- by gaining from capital appreciation.
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