Introduction

When Indian businesses need to obtain capital, they often resort to investment instruments such as preference shares and bonds. Both instruments will give the investor an opportunity to earn a continuous return on investment. However, they will be different with respect to risk, rewards, and rights. As an investor, whether salaried in Mumbai or retired in Bengaluru, it is critical to grasp these differences so that you can make informed decisions. Let’s discuss the two instruments, what they do, what benefits they provide and the associated risks concerning an Indian context.

What Are Preference Shares?

Preference shares (or preferred stock) are a slice of ownership in a corporation like equity shares listed on the BSE or NSE, but with the distinction that the investor will receive their entitlements before others regarding dividends (or liquidation). These investments are a hybrid of equity and fixed-income securities. For example, if an industry issued 6% preference shares, the payment would be ₹6 for every ₹100 invested in the shares and payable prior to any ordinary shareholders receiving payment. The dividends are usually fixed, thus more predictable. Therefore, in India, firms like Tata Steel and Mahindra & Mahindra have issued preference shares to gain capital taking advantage of the corporate investor seeking stable income with a little equity exposure.

However, dividends aren’t guaranteed. If the company hits a rough patch during an economic slowdown, it can skip dividend payments (though “cumulative” preference shares ensure unpaid dividends pile up for later). Plus, most preference shares in India don’t carry voting rights, so you won’t have a say in boardroom decisions unless dividends remain unpaid for long periods.

What Are Bonds?

Bonds, conversely, are loans made to a company or a government in return for regular interest. Bonds are debt instruments with no ownership whatsoever. When you purchase a bond, you are lending money, and the bond issuer will pay you interest (often referred to as a coupon) at some frequency along the way, along with your principal at the bond's defined maturity.

For instance, if you buy a ₹10,000 7% bond from NTPC, you will receive ₹700 per year as an interest payment, and at some point, in the future, you will receive your ₹10,000 back (let's say after 10 years). Similarly, popular bonds in India among conservative investors include some government securities (often referred to as G-Secs), PSU bonds from state-owned enterprises such as SBI, and corporate bonds from companies like HDFC. Payments of interest on bonds are legally binding, so in most circumstances, bonds will be viewed as safer than preference shares.

Preference shares vs bonds: The Key Difference

The main difference between preference shares and bonds is your role. Preference shares make you a partial owner of the company, a more junior owner than common voters in general, but an owner nonetheless. Bonds make you a creditor and a lender of your cash without any ownership claim with respect to the company's growth. This difference defines everything about your cash flow, risks, and rights.

Consider the example of an Indian company, e.g. Bharat Enterprises:

• Preference Shares: You purchase ₹10,000 worth of 6% preference shares. You will earn ₹600 a year in dividends on your preference shares, but Bharat may not pay dividends in certain years of losses (like in 2020 during the pandemic). In a bankruptcy situation, you will be paid dividends only after bondholders are paid.

• Bonds: You purchase ₹10,000 worth of 6% bonds. You will receive ₹600 in interest each year, and your ₹10,000 is paid back to you at the end of the bond term. In bankruptcy, you will be among the first to claim assets before all shareholders are paid.

Risk and Reward Trade-Off

Preference shares carry more risk than bonds. Since dividends depend on profits, a company struggling, like Jet Airways during its collapse, might halt payments. Bonds, however, offer greater security because interest is a legal obligation. Even if a company like IL&FS defaults, bondholders have a stronger claim on assets, and government bonds (like RBI bonds) are virtually risk-free.

That said, preference shares can offer higher rewards in good times. Some come with convertible features, letting you switch to equity shares if the company soars, like turning your stake into common shares of a booming firm like Infosys. Bonds rarely offer such upside, sticking to fixed returns unless they’re convertible (less common in India).

Time Horizon and Flexibility

Bonds have a clear end date, or maturity, when you get your principal back, perfect for planning, say, a child’s education in 10 years. Preference shares, however, are often perpetual, with no fixed end unless the company “calls” them back (redeems them early). This suits investors comfortable with long-term commitments but can feel less liquid.

For investors, bonds are easier to trade in secondary markets like the NSE’s debt segment, while preference shares are less liquid, often tied to specific corporate actions. During volatile markets, like the 2022 inflation spike, bonds (especially G-Secs) tend to hold value better.

Tax Implications in India

Taxation matters for Indian investors. Bond interest is taxed as income, per your slab rate (e.g., 30% for high earners). Preference shares dividends face a dividend distribution tax (DDT) at the company level (abolished in 2020), but now dividends are taxable in your hands, again per your slab. Bonds offer a slight edge for companies, as interest payments are tax-deductible, unlike dividends, which come from after-tax profits.

For retail investors, tax-saving bonds under Section 80CCF (like REC bonds) or capital gains bonds under Section 54EC can reduce tax burdens, making bonds more appealing for tax planning than preference shares.

Which Should You Choose?

Your choice depends on your goals and risk appetite:

• Preference Shares: Ideal if you want steady dividends with some equity exposure. They suit moderately risk-tolerant investors, like young professionals eyeing long-term wealth.

• Bonds: Bonds are best for safety and predictability. They’re perfect for retirees or conservative investors, especially with trusted issuers like the RBI or PSUs.

In India’s growing economy, both instruments have their place. A diversified portfolio might include PSU bonds for stability and preference shares from blue-chip firms for balanced growth. Always check the issuer’s credit rating, AAA-rated bonds, or financially sound companies to reduce risks.

Conclusion

Preference shares and bonds cater to different needs in India’s vibrant markets. Bonds offer security and fixed returns, acting like a dependable fixed deposit, while preference shares blend income with ownership, carrying more risk and potential rewards. Whether you’re in Delhi’s corporate world or managing savings in Chennai, weigh your financial goals, risk tolerance, and tax situation before choosing. Consulting a SEBI-registered advisor can further clarify which fits your portfolio best.

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