What Attributes Would Be Necessary to Classify a Preferred Stock As a Debt?
- Fixed income securities, such as bonds, pay a fixed amount of interest and return the principal at maturity. Their prices are primarily affected by interest rates, when interest rates go down, bonds go up, and vice versa. Bond prices are also affected by credit ratings and the financial condition of the issuer.
- Because bonds are repaid at face value at maturity, their upside is limited. Preferred stocks are perpetual securities -- that is, they have no maturity dates, but most are issued with a call provision -- the ability of the issuer to call, or redeem, them under certain conditions at a future date. Preferred stocks are typically called at par -- the face value with which they are issued. If investors know that a preferred stock can be called at par they will not be willing to pay much above par for it.
- Bonds pay interest, preferred stocks pay dividends. Since preferred stocks' upside is limited, the only benefit of owning them is the high current income. Whether that income is called interest (as in debt) or dividends (as in preferred stocks) does not matter much to fixed income investors, who buy both types of securities for the current income. Changing interest rates will therefore have the same effect on preferred stocks as they do on bonds.
- When a corporation is liquidated in bankruptcy, its obligations are paid in a particular order of priority. Preferred stockholders are paid after debt holders -- banks and bondholders - but both are ahead of the common stockholders, who usually get wiped out in a corporate bankruptcy.
- Since preferred stockholders are primarily concerned about current income, they want to make sure that the company cash flow is sufficient to cover the preferred dividends. Since preferred stocks are riskier than debt because debt is paid off first in bankruptcy, an issuer's credit rating is even more important for evaluating preferred stocks than it is for bonds/debt. On the other hand, many common stocks may stage powerful runs even when the issuer's credit rating is low or falling.
