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Bonds are debt instruments that enable the issuer to borrow funds in exchange for periodic interest payments and the return of the principal at the end of a predetermined span of time. Preferred stock shares are more similar to debt instruments than common stock shares, enabling their shareholders to collect annual dividends but not to vote on important corporate decisions. Both bonds and preferred shares accord their holders precedence over common shareholders in regards to payment.
Corporations issue shares in their capital stock in exchange for investments of economic resources into their operations. For example, if a shareholder signs over ownership of a vehicle to the corporation, that shareholder can be compensated with shares in the corporation. Common shares accord their holders the right to vote on important decisions, including the election of the corporation's board of directors. Common shareholders are not entitled to collect dividends unless declared.
Bonds and Preferred Shares
Bonds are debt instruments, while preferred shares are equities that resemble debt instruments. Both possess precedence over common shares in terms of payment because the issuer is obligated to honor their terms. For bonds, this is the payment of the interest charged on the bond and the return of the principal at the bond's end. For the preferred share, this is the right of its shareholder to collect dividends in each and every year. Even in years where no dividends are declared, preferred dividends accumulate to be paid out in the next year when dividends are declared.
Corporations can go bankrupt and be liquidated as a result of that bankruptcy. Liquidation means that the corporation sells off all of its assets to pay off as much of its obligations as possible. Liquidation occurs whenever interested parties cannot come to an agreement on deferring the corporation's debts or when it simply isn't possible or worth it to even attempt to restructure its operations in order to regain profitability.
Order of Precedence
A strict sequence exists in regards to which of a corporation's economic obligations are paid off first upon liquidation. The first obligations to be paid off are the expenses incurred as a result of the business's bankruptcy and subsequent transactions. The second set of obligations is secured debt, meaning debt with attached collateral. Following that is unsecured debt, including most bonds. Shareholders come last after unsecured debtors, with preferred shareholders taking precedence over common shareholders. In most cases, there likely isn't anything left for common shareholders by the time that the corporation's other obligations are paid off.
Alan Li started writing in 2008 and has seen his work published in newsletters written for the Cecil Street Community Centre in Toronto. He is a graduate of the finance program at the University of Toronto with a Bachelor of Commerce and has additional accreditation from the Canadian Securities Institute.