Is Preferred Stock Considered Fixed Income?

Many individuals seeking stable income from their investments often encounter a specific financial instrument: preferred stock. This security often prompts questions about its classification, especially whether it functions as a fixed income investment. Confusion arises because preferred stock resembles both traditional equity, like common stock, and debt instruments, such as bonds. This article explores the distinct features of preferred stock and fixed income securities, clarifying their fundamental differences and similarities. Understanding these distinctions is important for investors.

Characteristics of Preferred Stock

Preferred stock represents an ownership stake in a company, similar to common stock, but it has unique differentiating features. A primary characteristic is its typical fixed dividend payment, usually expressed as a percentage of its par value. These dividends are generally paid to preferred shareholders before any dividends are distributed to common stockholders.

In liquidation, preferred shareholders hold a higher claim on company assets than common shareholders. They are prioritized in receiving payment from remaining assets after creditors and bondholders. However, unlike common stock, preferred stock typically does not grant voting rights, meaning holders cannot vote on corporate matters or elect board members.

Another feature is callability, allowing the issuing company to redeem shares at a predetermined price after a specific date. This allows the issuer to repurchase the stock, often when interest rates decline, potentially impacting an investor’s income stream. Preferred stock can also be cumulative or non-cumulative; cumulative preferred stock requires that any missed dividend payments must be paid before common stockholders receive dividends, while non-cumulative preferred stock does not have this requirement.

Characteristics of Fixed Income Securities

Fixed income securities represent a loan from an investor to a borrower, such as a corporation or government entity. These debt-based instruments mean the investor acts as a lender expecting regular, predictable payments. These payments are typically interest, paid over a specified period.

A defining feature of fixed income securities is the promise of returning the principal to the investor upon a predetermined maturity date. This date signifies when the borrower must repay the security’s full face value. Common examples include corporate bonds and government bonds, such as U.S. Treasury securities, considered very low risk due to U.S. government backing.

Municipal bonds, issued by state and local governments, are another fixed income security, often offering tax advantages. Certificates of Deposit (CDs), offered by banks, also fall under this category, providing a fixed interest rate for a set period. The core concept across all these is their nature as debt instruments, providing a structured repayment schedule and principal return, distinguishing them from equity investments.

Preferred Stock Versus Fixed Income

While preferred stock shares superficial resemblances with fixed income securities, their fundamental legal and financial structures differ significantly. Both typically offer regular, predictable payments to investors, a primary reason for common confusion. Preferred stock pays dividends, often at a fixed rate, while fixed income securities pay interest.

The most important distinction lies in their legal standing: preferred stock is an equity instrument, signifying ownership in a company, whereas fixed income is a debt instrument, establishing a lender-borrower relationship. This equity classification means preferred shareholders are owners, albeit with limited rights, while fixed income holders are creditors. Unlike most fixed income securities with a defined maturity date where principal is returned, preferred stock is typically perpetual, meaning it has no maturity date and principal is not returned unless shares are called or the company liquidates.

In bankruptcy, fixed income instruments, particularly bonds, hold a higher claim on assets and income than preferred stock. Bondholders are paid before preferred shareholders, who are paid before common shareholders. This hierarchy means preferred stock carries more risk in insolvency scenarios than traditional debt. The tax treatment also varies; preferred stock dividends can often qualify as “qualified dividends” under U.S. tax law, potentially taxed at lower capital gains rates, while bond interest is typically taxed as ordinary income at higher rates.

Callability is present in both, but its implications differ. Many preferred stocks are callable, allowing the issuer to redeem them, which can force an investor to reinvest at potentially lower rates. While some bonds are also callable, prevalence and typical terms can vary. Both are subject to interest rate risk, meaning their market value can fluctuate inversely with changes in interest rates. However, preferred stock also carries greater equity-like risks, such as higher sensitivity to the issuing company’s financial performance and creditworthiness, as dividend payments are not guaranteed like bond interest payments.