Preferred shares and debentures are two different kinds of financial instruments. They share many similarities but their differences are what make them good for different investors.
Preferred or preference shares are shares of a company’s stock that are issued to preferred shareholders or stockholders.
Just like common stocks, preferred shares represent ownership in a company. The difference is that preference shares do not usually grant voting rights but they give the holder of the share a claim of quarterly dividends and precedence over common stockholders should the company liquidates itself or go out of business.
Four types of preference shares exist, and they are called cumulative preferred stock, non-cumulative preferred stock, participating preferred stock, and convertible preferred stock.
Preferred stocks are a good alternative for risk-averse equity investors. They can be considered to be between common stocks and corporate bonds in terms of the risk they carry.
Preferred stocks can provide steady flow of dividends similar to an interest payment that is promised to bondholders. Preferred shareholders also rank higher than common stock for liquidation rights, although they still rank behind debentures.
Debentures are a corporate or government bond that is not secured by an asset. All kinds of debentures are bonds, but not all bonds are debentures. Secured bonds belong within their own class and they can be identified by the collateral associated with the bond.
The structuring of the debenture makes it riskier than a secured debt instrument since collateral does not back it. On the other hand, debentures have less risk than preferred s tocks due to their senior liquidation rights.
Being debt instruments, debentures fall senior to preferred shares if bankruptcy or liquidation were to happen.
There are two main kinds of debentures, namely convertible debentures and non-convertible debentures.
All debentures follow a standard structuring process and they have similar features. First, a trust indenture is made. It is an agreement between the issuer and the trust that manages the interest of investors.
Next, the coupon rate is decided, which is the rate of interest that the company will pay the debenture holder or investor. This rate can be either floating or fixed depending on the company’s credit rating or the bond’s credit rating.
Debentures usually get a higher interest rate payment when compared to secured debt to offset some of the collateral risks. Each debenture agreement will also detail the seniority of repayment in the event of liquidation.
The holders of debentures will receive payments before preferred shareholders but may fall behind other types of debts in the company’s books like senior loans. If the funds permit, the holder of the debenture may receive the full payment of the bond principal with interest. Every liquidation is different and will affect the final payout to a debenture holder.
The main consideration when choosing between preferred shares and debentures depend on risk. Preferred shareholders are usually promised dividend payments and some liquidation rights. On the other hand, shares still trade openly on an exchange with a value that is primarily dictated by the market.
A debenture can be less risky when compared to preferred shares but it will also typically have a lower expected return. With a debenture, the owner is promised full repayment of the principal investment plus the interest over a specific period.
Debentures are also higher on the seniority ranking for reimbursement if a company has to liquidate.