Identify The Two Types Of Preferred Dividends

Preferred dividends are a unique aspect of preferred stock, offering investors a distinct income stream compared to common stock. Understanding the nuances of these dividends, especially the two main types, is crucial for anyone looking to diversify their investment portfolio. Preferred stock combines features of both debt and equity, and the dividends attached to them are a key reason why investors find them attractive.

Understanding Preferred Stock and Dividends

Before diving into the types of preferred dividends, it's essential to grasp what preferred stock is and how it differs from common stock. Preferred stock is a class of ownership in a corporation that has a higher claim on assets and earnings than common stock. This means that in the event of bankruptcy, preferred stockholders are paid before common stockholders.

Key characteristics of preferred stock:

• Fixed Dividends: Unlike common stock, preferred stock typically pays a fixed dividend, similar to a bond's coupon payment. This fixed income is one of the primary attractions for investors.
• Higher Claim on Assets: As mentioned earlier, preferred stockholders have a higher claim on the company's assets than common stockholders, but lower than bondholders.
• No Voting Rights: In most cases, preferred stockholders do not have voting rights, which is a significant difference from common stockholders.
• Hybrid Security: Preferred stock is often considered a hybrid security because it has features of both debt (fixed income) and equity (ownership in the company).

Preferred dividends, therefore, are the fixed payments that preferred stockholders receive. These dividends are usually paid quarterly, and they must be paid before any dividends are paid to common stockholders. This priority in dividend payments is a major advantage of holding preferred stock.

The Two Main Types of Preferred Dividends

The two primary types of preferred dividends are cumulative and non-cumulative. Understanding the difference between these two is critical for investors as it directly impacts the potential income they can receive from their investment.

1. Cumulative Preferred Dividends

Cumulative preferred stock is the more common and generally more investor-friendly type of preferred stock. With cumulative preferred stock, if a company misses a dividend payment (perhaps due to financial difficulties), the unpaid dividends accumulate. These accumulated dividends, known as dividends in arrears, must be paid out to cumulative preferred stockholders before any dividends can be paid to common stockholders.

Key features of cumulative preferred dividends:

• Accumulation of Unpaid Dividends: If a dividend payment is skipped, it accumulates and must be paid in the future.
• Priority in Payment: All accumulated dividends must be paid to cumulative preferred stockholders before common stockholders receive any dividends.
• Reduced Risk: Cumulative preferred stock is generally considered less risky than non-cumulative preferred stock because of the assurance that unpaid dividends will eventually be paid.
• Investor Protection: This type of dividend provides a level of protection for investors, ensuring they receive all the dividends they are entitled to, even if the company faces temporary financial challenges.

Example of Cumulative Preferred Dividends:

Let's say a company issues cumulative preferred stock with an annual dividend of $5 per share. If the company skips the dividend payment for two years due to financial constraints, the cumulative preferred stockholders are owed $10 per share in accumulated dividends ($5 per year x 2 years). Before the company can pay any dividends to common stockholders, it must first pay the $10 per share to the cumulative preferred stockholders.

Why Choose Cumulative Preferred Stock?

Investors often prefer cumulative preferred stock because it offers a greater degree of safety and predictability. In times of economic uncertainty or company-specific challenges, the assurance that unpaid dividends will accumulate and eventually be paid provides peace of mind. This makes cumulative preferred stock particularly attractive to risk-averse investors or those seeking a steady income stream.

2. Non-Cumulative Preferred Dividends

Non-cumulative preferred stock is a less common type of preferred stock and generally considered riskier for investors. With non-cumulative preferred stock, if a company misses a dividend payment, the unpaid dividend does not accumulate. In other words, the investor loses the right to receive that dividend payment forever.

Key features of non-cumulative preferred dividends:

• No Accumulation of Unpaid Dividends: If a dividend is skipped, it is simply lost, and the company is not obligated to pay it in the future.
• No Priority for Missed Dividends: Unlike cumulative preferred stock, there is no obligation to pay missed dividends to non-cumulative preferred stockholders before paying dividends to common stockholders.
• Higher Risk: Non-cumulative preferred stock is generally considered riskier than cumulative preferred stock due to the lack of assurance that unpaid dividends will ever be received.
• Company Flexibility: This type of dividend provides the company with greater flexibility, as it is not burdened by the obligation to pay accumulated dividends in arrears.

Example of Non-Cumulative Preferred Dividends:

Suppose a company issues non-cumulative preferred stock with an annual dividend of $5 per share. If the company skips the dividend payment for one year due to financial difficulties, the non-cumulative preferred stockholders simply lose the right to that $5 per share dividend payment. The company is not obligated to pay it in the future, and the investors will not receive it.

Why Choose Non-Cumulative Preferred Stock?

Given the higher risk, investors might wonder why anyone would choose non-cumulative preferred stock. The primary reason is that non-cumulative preferred stock typically offers a higher dividend yield than cumulative preferred stock. This higher yield is intended to compensate investors for the increased risk they are taking.

Additionally, companies that issue non-cumulative preferred stock may be in a stronger financial position or have a more stable outlook, making the risk of missed dividend payments lower. In such cases, investors may be willing to accept the higher risk for the potential of a higher return.

Factors Influencing Preferred Dividend Payments

Several factors can influence a company's ability to pay preferred dividends, regardless of whether they are cumulative or non-cumulative. Understanding these factors can help investors assess the risk associated with their investment.

1. Financial Health of the Company:

The most significant factor influencing dividend payments is the overall financial health of the company. A company with strong revenues, healthy profits, and a solid balance sheet is more likely to consistently pay its preferred dividends. Conversely, a company facing financial difficulties, such as declining revenues, increasing debt, or significant losses, may be more likely to suspend or reduce dividend payments.

2. Industry Conditions:

The industry in which a company operates can also impact its ability to pay dividends. Companies in stable, mature industries are generally more likely to maintain consistent dividend payments than those in volatile, rapidly changing industries. Economic downturns or disruptions in the industry can affect a company's financial performance and, consequently, its ability to pay dividends.

3. Company Policy:

A company's dividend policy is another important factor to consider. Some companies have a long-standing tradition of paying dividends and prioritize maintaining those payments, even during challenging times. Other companies may be more flexible with their dividend policy, adjusting payments based on current financial performance and strategic priorities.

4. Legal and Regulatory Requirements:

Legal and regulatory requirements can also influence dividend payments. Companies must comply with various regulations regarding dividend payments, including solvency requirements and restrictions on paying dividends if the company is insolvent or in financial distress.

5. Cash Flow:

Sufficient cash flow is essential for a company to pay dividends. Even if a company is profitable, it may not have enough cash on hand to cover dividend payments if it has significant capital expenditures, debt obligations, or other cash demands.

Advantages and Disadvantages of Preferred Stock

Investing in preferred stock, with its cumulative or non-cumulative dividends, offers several advantages and disadvantages that investors should carefully consider.

Advantages:

• Higher Dividend Yield: Preferred stock typically offers a higher dividend yield than common stock, making it attractive to income-seeking investors.
• Priority in Dividend Payments: Preferred stockholders have priority over common stockholders in receiving dividend payments.
• Higher Claim on Assets: In the event of bankruptcy, preferred stockholders have a higher claim on the company's assets than common stockholders.
• Fixed Income Stream: The fixed dividend payments provide a predictable income stream, similar to bonds.
• Diversification: Preferred stock can be a useful tool for diversifying an investment portfolio, providing a balance between debt and equity.

Disadvantages:

• Limited Growth Potential: Unlike common stock, preferred stock typically does not offer the same potential for capital appreciation.
• No Voting Rights: In most cases, preferred stockholders do not have voting rights, limiting their influence on company decisions.
• Interest Rate Risk: Preferred stock prices can be sensitive to changes in interest rates, potentially leading to capital losses.
• Call Risk: Some preferred stock is callable, meaning the company can redeem the shares at a specified price, potentially limiting the investor's upside.
• Credit Risk: The creditworthiness of the issuing company can impact the value of preferred stock, particularly if the company's financial health deteriorates.

How to Evaluate Preferred Stock

When evaluating preferred stock, investors should consider several key factors to assess its suitability for their investment goals.

1. Dividend Yield:

The dividend yield is the annual dividend payment divided by the current market price of the preferred stock. A higher dividend yield may be attractive, but it's essential to consider the sustainability of the dividend payment.

2. Credit Rating:

The credit rating of the issuing company provides an indication of its creditworthiness and ability to meet its financial obligations, including dividend payments. Higher-rated companies are generally considered less risky.

3. Financial Health of the Company:

A thorough analysis of the company's financial statements, including its income statement, balance sheet, and cash flow statement, can provide insights into its financial health and ability to maintain dividend payments.

4. Cumulative vs. Non-Cumulative:

As discussed earlier, understanding whether the preferred stock is cumulative or non-cumulative is crucial. Cumulative preferred stock offers greater protection for investors, while non-cumulative preferred stock typically offers a higher yield to compensate for the increased risk.

5. Call Provisions:

Check whether the preferred stock is callable and, if so, under what terms. Callable preferred stock may limit the investor's upside potential.

6. Liquidity:

Consider the liquidity of the preferred stock, which refers to how easily it can be bought and sold in the market. More liquid preferred stock is generally easier to trade and may offer better pricing.

Tax Implications of Preferred Dividends

The tax implications of preferred dividends can vary depending on the investor's individual circumstances and the tax laws in their jurisdiction. In general, preferred dividends are treated as ordinary income for tax purposes, meaning they are taxed at the investor's regular income tax rate.

However, in some cases, preferred dividends may qualify for the lower tax rates applicable to qualified dividends. To qualify for these lower rates, the preferred stock must meet certain holding period requirements, and the dividends must be paid by a U.S. corporation or a qualified foreign corporation.

It's essential for investors to consult with a tax professional to understand the specific tax implications of preferred dividends in their individual circumstances.

Real-World Examples

To illustrate the concepts discussed, let's look at some real-world examples of companies that issue preferred stock.

1. Bank of America:

Bank of America is a well-known issuer of preferred stock. Its preferred shares offer investors a fixed dividend yield and priority over common stockholders in dividend payments. Bank of America's preferred stock is often used by income-seeking investors looking for a stable return.

2. Wells Fargo:

Wells Fargo is another major bank that issues preferred stock. Similar to Bank of America, Wells Fargo's preferred shares provide a fixed income stream and a higher claim on assets than common stock.

3. General Electric (GE):

General Electric has also issued preferred stock in the past. While GE has faced financial challenges in recent years, its preferred shares have historically been a popular choice for investors seeking income.

4. Enterprise Products Partners L.P.:

Enterprise Products Partners, a midstream energy company, issues preferred units that function similarly to preferred stock. These units offer a fixed distribution and are often favored by investors in the energy sector.

These examples demonstrate that preferred stock is issued by a wide range of companies across various industries, providing investors with diverse investment opportunities.

Conclusion

Understanding the different types of preferred dividends, specifically cumulative and non-cumulative, is essential for making informed investment decisions. Cumulative preferred stock offers greater protection for investors, while non-cumulative preferred stock typically offers a higher yield to compensate for the increased risk. By carefully evaluating the factors that influence dividend payments and considering the advantages and disadvantages of preferred stock, investors can determine whether it aligns with their investment goals and risk tolerance.