Why Preferred Stock Is Considered Debt
Many investors consider preferred stock a form of debt because of its similarities to bonds. Both instruments are rated by credit rating agencies and can be bought back by the issuing company and converted into common stock. However, one of the main reasons companies issue preferred stock is to improve their balance sheets. Preferred stock is equity and does not show as debt on their books.
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Ratings
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Preferreds are similar to bonds because both instruments are rated by credit rating agencies. In the case of preferred stock, agencies such as Moody's or Standard & Poor's rate a company's ability and willingness to pay dividends. Ratings for preferred stock are usually slightly lower than those for bonds, reflecting the fact that payment of dividends is less guaranteed than that of interest from bonds.
Callability
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Unlike bonds, which come with a fixed maturity date, preferred stock has unlimited life, putting the issuing company under obligation to pay dividends forever. To prevent this from happening, the company can issue a redeemable, or callable preferred stock, which allows it to buy that stock back after a certain date. As with bonds, the company would do that if the current market rate is lower than the one it pays. For that privilege, it would have to pay a higher price than that stated on the stock.
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Convertibility
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In another similarity to bonds, preferred stock can be converted into common stock, either at the request of a stockholder or sometimes by the issuing company. The price of convertible preferred stock usually falls when interest rates go up and rises when interest rates go down.
Debt Obligations
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In terms of debt obligations, preferred stock falls somewhere between bonds and common stock. If the issuing company goes into liquidation, bond holders are the first in line to get some or all of their money back. If any money is left, it goes to preferred stock holders, while the common stock holders are the last. Interest and dividend payments are similar. A company makes interest payments to bondholders first, followed by dividend payments to holders of preferred stock, with common stock holders last again. Although the company is under no obligation to pay dividends, it will probably try to pay them to preferred stockholders. The company is prohibited from paying dividends to common stockholders and its own managers until it pays preferred stockholders first.
Equity
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The main reason a company might issue preferred stock is because money raised this way shows as equity on the company's books. This improves the company's debt-to-equity ratio, which in industries such as banking and insurance is legally mandated. Also, money raised through preferred stock does not have a negative effect on the company's credit rating, which is very important if the company later needs to borrow more money. In order to sell preferred stock, which does not have the same potential for growth as common stock, the company must offer investors higher dividends than those from common stock.
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