Preferred Bond vs. Other Investments: Key Differences Explained

Investors looking for income-generating assets often compare preferred bonds with common stocks, corporate bonds, and government securities. Each has distinct characteristics that impact risk, return, and suitability for different financial goals. Understanding these differences helps investors make informed decisions.

Preferred bonds share traits with both stocks and traditional bonds but have unique features that set them apart. Examining their structure, payment terms, and market behavior can help investors determine whether they align with their portfolio strategy.

Unique Structural Elements

Preferred bonds blend characteristics of debt and equity. Unlike corporate bonds, which have fixed maturity dates, preferred bonds often have perpetual or long-dated maturities, meaning they can remain outstanding indefinitely or for decades. This extended duration increases exposure to interest rate risk, as rising rates can erode market value.

Their payment structure differs from standard corporate bonds. While most bonds pay fixed interest, preferred bonds may offer either fixed or floating payments tied to benchmark rates like the Secured Overnight Financing Rate (SOFR). This flexibility helps in fluctuating rate environments but also introduces variability, which may not suit investors seeking stable income.

Some preferred bonds include conversion provisions, allowing holders to exchange them for common stock at a predetermined ratio. This feature provides potential upside if the issuing company’s stock price rises but also exposes investors to market volatility. While convertibility can enhance returns, it also carries dilution risk if the company issues more shares.

Capital Hierarchy

Preferred bonds rank above common stock but below traditional corporate bonds in a company’s capital structure. In financial distress or bankruptcy, preferred bondholders are repaid before equity investors but after senior and subordinated debt holders.

Because they lack the legal protections of senior debt, preferred bonds typically offer higher yields to compensate for the increased risk. Unlike secured bonds backed by specific assets, preferred bonds are usually unsecured, meaning repayment depends on the issuer’s financial health rather than collateral. If a company liquidates, secured creditors and senior bondholders are first in line, leaving preferred bondholders with a lower chance of full repayment.

Debt covenants can also impact preferred bond payments. Many corporate debt agreements prioritize interest payments on senior bonds before any distributions to preferred securities. If an issuer faces financial difficulties, payments on preferred bonds may be suspended even if the company remains solvent. Investors should assess an issuer’s debt structure to gauge the likelihood of uninterrupted payments.

Payment Arrangements

Preferred bonds have structured payment terms that distinguish them from other income-generating securities. Unlike common stock, where dividends are discretionary, preferred bond payments are generally fixed and must be made before any distributions to equity holders. However, payments can still be suspended under specific conditions outlined in the bond’s prospectus.

A key distinction is whether the bond is cumulative or non-cumulative. Cumulative preferred bonds require issuers to make up any missed payments before resuming dividends to common shareholders. Non-cumulative issues do not obligate companies to repay skipped distributions, making them riskier for investors seeking consistent income. Many financial institutions issue non-cumulative preferred bonds to maintain flexibility, particularly during economic downturns when regulators may impose payout restrictions.

Some preferred bonds also include deferred interest provisions, allowing issuers to postpone payments for a set period without triggering default. While this can provide financial relief for companies, it introduces uncertainty for investors. Credit rating agencies factor these provisions into risk assessments, making it important for investors to review payment terms before committing capital.

Call and Redemption Options

Issuers often retain the right to redeem preferred bonds before maturity. Callable preferred bonds allow companies to repurchase them at a predetermined price after a specified call date. This benefits issuers, particularly when interest rates decline, as they can refinance at lower costs. However, investors face reinvestment risk, as called bonds may force them to reinvest at lower yields.

Redemption terms vary. Some bonds feature step-call structures where the call price declines over time. For example, a preferred bond callable at 105% of par in the first five years may drop to 102% after a decade, eventually settling at par value. Early redemptions provide premium payouts, while later calls reduce potential gains. Investors should review call schedules to assess the likelihood of early redemption affecting their investment horizon.

Tax Considerations

Tax treatment affects the attractiveness of preferred bonds compared to other investments. Unlike common stock dividends, which may qualify for lower tax rates, preferred bond payments are often taxed as ordinary income, which can reduce after-tax returns.

Certain preferred bonds issued by corporations may qualify for the dividends-received deduction (DRD) if held by another corporation, reducing taxable income. Some preferred securities also pay qualified dividends, which are taxed at the lower capital gains rate rather than as ordinary income. However, trust-preferred bonds—often issued by financial institutions—are taxed as interest income, eliminating tax advantages. Investors should review a bond’s tax classification to determine its impact on portfolio efficiency.

Municipal preferred bonds offer another tax consideration, as their interest may be exempt from federal and, in some cases, state and local taxes. This tax-exempt status can enhance after-tax yields for high-income investors. However, municipal preferreds are less common than corporate issues, and their lower yields may not always offset the tax benefits. Evaluating tax implications alongside yield and risk factors is essential when comparing preferred bonds to other fixed-income investments.

Market Access

Liquidity and accessibility influence an investor’s ability to buy and sell preferred bonds efficiently. Unlike common stocks, which trade on major exchanges, preferred bonds often have lower liquidity, leading to wider bid-ask spreads and potential price inefficiencies. This reduced trading activity can make it harder to exit a position quickly, particularly in volatile markets.

Institutional investors, such as pension funds and insurance companies, dominate the preferred bond market, limiting retail investor participation. Many preferred bonds trade over-the-counter (OTC) rather than on centralized exchanges, requiring investors to work with brokers to execute transactions. This structure can result in higher transaction costs and less price transparency compared to exchange-listed securities. Additionally, minimum investment sizes for certain preferred issues may be higher than those for common stocks or traditional corporate bonds, creating barriers for smaller investors.

Exchange-traded preferred securities offer a more accessible alternative, providing liquidity similar to stocks while maintaining the characteristics of preferred bonds. These instruments trade on major exchanges like the NYSE and Nasdaq, making them easier to buy and sell for individual investors. However, they may still experience periods of low trading volume, particularly for less widely held issues. Understanding the liquidity profile of a preferred bond is important for investors who may need to adjust their holdings in response to changing market conditions.