Preferred Dividends: How Fixed-Income Investing Works

In market ups and downs, preferred dividends stand out as an appealing option for those who value predictability and priority in returns.

But what exactly makes them such a valuable asset for income-focused investors?

In this guide, we’ll cover what sets preferred dividends apart, from their unique payout structure to their tax benefits and market trends. In our experience working with clients in private equity and venture capital, preferred dividends are a must to understand.

Let’s find out why preferred dividends might be the reliable choice your portfolio needs.

Understanding Preferred Dividends

Preferred dividends are payments made to preferred shareholders, who have a higher claim on a company’s earnings and assets than common shareholders.

This means they get paid dividends before common shareholders and, in certain cases, have priority if the company faces financial trouble. From what I’ve seen, this priority makes preferred dividends attractive to investors looking for steady, reliable income. As Mark Kaminski, Senior Portfolio Manager at Addenda Capital, has said in his article, “Payment of dividends ranks above common shares, providing a consistent income stream that can be attractive in an uncertain economic environment.”

Preferred dividends usually come with a fixed rate based on the stock’s par value, giving investors regular income – often paid monthly or quarterly.

A key feature is that many preferred dividends are cumulative.

If a company misses a payment, it must make up for it before paying any dividends to common shareholders. This feature provides added protection, ensuring preferred shareholders receive any missed payments over time.

Unlike common dividends, preferred dividends usually don’t increase if a company’s profits rise, as they’re set at a fixed rate. This makes preferred dividends similar to bonds, offering predictable income along with priority in payouts.

Types of Preferred Dividend Payments

Preferred dividends come in various forms, each with its unique characteristics and benefits. Understanding these types can help investors make informed decisions about their portfolios.

• Fixed Rate Dividends: These are the most common type of preferred dividends, offering a fixed rate based on the par value of the stock. This predictability makes them a popular choice for investors seeking steady income.

• Adjustable Rate Dividends: Unlike fixed rate dividends, adjustable rate dividends can fluctuate based on certain benchmarks, such as the London Interbank Offered Rate (LIBOR). This flexibility can be advantageous in changing economic conditions.

• Participating Dividends: These dividends offer an additional payout based on the company’s profits or the dividends paid to common shareholders. Participating dividends can provide a higher return when the company performs well, making them an attractive option for investors looking for growth potential.

• Cumulative vs Non-Cumulative Dividends: Cumulative dividends require that any missed payments be eventually paid to preferred shareholders before common shareholders can receive dividends. Non-cumulative dividends, however, do not offer this protection, meaning missed payments are forfeited.

Calculating Preferred Dividend Rates

Calculating preferred dividend rates is simple and helps investors see the expected return on their investment. To find the total annual preferred dividend, multiply the dividend rate by the par value of the preferred stock:

• Total Annual Dividend = Dividend Rate × Par Value

This formula gives investors a clear view of the annual income they can expect from their preferred shares.

If dividends are paid in installments (like quarterly), divide the total annual dividend by the number of payment periods to find the amount for each period. This way, investors receive a steady income throughout the year, making it easier to plan finances. For example:

• Quarterly Dividend = Total Annual Dividend ÷ 4

Keep these formulas in mind to better estimate your income and make informed financial plans throughout the year.

Cumulative vs Non-Cumulative Preferred Dividends

Understanding the difference between cumulative and non-cumulative preferred dividends is crucial for investors. Each type offers distinct advantages and considerations:

Cumulative Preferred Dividends provide a safety net by requiring that any missed payments be eventually made up before common shareholders receive dividends. This is particularly beneficial in uncertain times, as it ensures preferred shareholders are prioritized for payments.

• Case in point: In 2011, Berkshire Hathaway invested $5 billion in Bank of America, purchasing preferred stock with a 6% annual dividend. Over six years, Berkshire Hathaway received approximately $1.8 billion in dividends (6 years * $300 million per year), illustrating how preferred dividends can generate a large income stream—even when economic conditions fluctuate.

In contrast, Non-Cumulative Preferred Dividends do not require companies to make up for missed payments.

If a payment is skipped, it is permanently forfeited, which can be a drawback for income-focused investors, particularly if the company faces financial difficulties. However, non-cumulative dividends offer companies more cash flow flexibility, making them an appealing choice for firms needing to prioritize other expenses or manage tighter budgets.

Priority in Bankruptcy

Preferred shareholders, both cumulative and non-cumulative, generally have a priority claim over common shareholders for dividend payments. This priority extends to bankruptcy scenarios, where preferred shareholders stand ahead of common shareholders for asset distribution. However, bondholders remain first in line, meaning preferred shareholders may still lose out if the company’s funds are insufficient to cover all debts.

Summary of Key Differences:

• Cumulative Dividends: Provide assurance that missed payments are recovered before common shareholders receive dividends, adding security for investors.
• Non-Cumulative Dividends: Lack the guarantee of missed payments, which can benefit companies’ cash flow but may increase risk for investors.

Understanding these distinctions allows investors to align their choices with their financial goals, offering diverse options to suit varied investment strategies.

Legal Requirements for Preferred Dividend Payments

Understanding the legal framework around preferred dividend payments is essential for investors.

In general, a corporation’s board of directors has the authority to declare dividends, as stated in Section 170 of the Delaware General Corporation Law (DGCL).

This means that the board can decide when and how much dividend to pay, but this power is not unlimited. A company’s certificate of incorporation may include restrictions, such as preventing dividend payments on common stock if preferred stock obligations are still outstanding.

Stock exchanges also have rules to ensure transparency.

For example, the New York Stock Exchange (NYSE) requires listed companies to notify the exchange at least ten calendar days before the record date for a dividend. The record date is crucial because it determines which shareholders are eligible to receive the dividend. This date typically falls between the declaration and payment dates, ensuring that only shareholders on record at that time receive the dividend.

Tax Treatment of Preferred Dividends

The tax treatment of preferred dividends is an important factor for both corporations and investors to consider.

Corporations can generally deduct dividends paid within the taxable year, although this deduction may be limited by dividend distribution preferences. For shareholders, preferred dividends are typically taxed as ordinary income. However, I’ve noticed that there are some exceptions—such as trust preferreds, which are taxed differently due to their bond-like characteristics.

Non-cumulative preferred shareholders may face higher tax rates on their dividends, sometimes up to 35%, which can make these dividends less attractive to high-income investors. This potential tax burden is a key consideration for those in higher tax brackets when deciding whether to hold preferred stock.

Preferred Dividends in Capital Structure Analysis

In capital structure analysis, preferred dividends are a key factor in evaluating a company’s financial stability and investment appeal. Because preferred stock combines elements of both equity and debt, it adds a unique layer to a company’s structure, influencing how resources are allocated and impacting overall financial leverage and risk profile.

Preferred shares offer several distinctive benefits for investors and companies alike:

• Predictable Income: Often paid at a fixed rate, preferred dividends provide investors with more stable income compared to common stock.
• Credit Ratings: Many preferred shares receive ratings from credit agencies, providing an extra level of security by offering insights into the company’s creditworthiness.
• Balance Sheet Transparency: Preferred dividends are consistently recorded on the balance sheet, which can make them easier to track than common stock dividends, typically declared at the fiscal year-end.

The inclusion of preferred stock affects a company’s capital-raising abilities and dividend obligations. Because preferred shareholders hold priority in dividend distribution, companies with preferred shares must manage cash flow effectively to meet these obligations, impacting their overall financial strategy and risk tolerance.

Understanding these dynamics is essential for investors who want to make informed decisions about capital allocation within a company’s broader capital structure.

Market Trends in Preferred Dividend Rates

Preferred dividend rates are a hot topic for investors aiming to balance risk and reward.

In our 10+ years of working in the investing landscape, we’ve observed that preferred dividends remain attractive due to their relatively high yields compared to other asset classes, even during market fluctuations.

As of June 30, 2015, the S&P U.S. Preferred Stock Index had a median dividend coupon rate of 6.45%. Recently, preferred dividend yields, measured by the PVAR Index, are around 6.8%—lower than the 10% spike seen during the 2023 bank failures but still above the long-term average of 5%.

Many preferred dividends currently offer yields in the 7–9% range, and some new securities provide tax-equivalent yields over 7%, making preferred dividends appealing in today’s low-interest-rate environment.

Historically, preferred dividends have consistently offered higher yields compared to many other income-generating assets. For example:

• Data from S&P Dow Jones Indices shows that in 2015, the S&P U.S. Preferred Stock Index had a yield of 6.52%, significantly higher than the S&P 500’s yield of 2.01%.
• Over the past decade, preferred dividend yields have generally ranged between 6% and 8%.

These stable and relatively high yields make preferred dividends attractive to income-focused investors looking for dependable income sources, even during market fluctuations.

Frequently Asked Questions

Can companies reduce or suspend preferred dividends?

Yes, companies can reduce or suspend preferred dividends if they face financial difficulties. However, cumulative preferred dividends would require that any missed payments be made up before dividends are paid to common shareholders.

What happens to preferred dividends in a corporate merger or acquisition?

In a merger or acquisition, preferred dividends may be renegotiated, and shareholders might receive cash payouts, stock in the new company, or other forms of compensation. The treatment of preferred dividends will vary based on the terms of the merger or acquisition agreement.

Are preferred dividends sensitive to economic cycles?

Yes, preferred dividends can be affected by economic cycles, particularly during economic downturns. Companies may suspend dividends to preserve cash, which could impact non-cumulative preferred shareholders. However, sectors like utilities and financials, which often issue preferred shares, tend to be less sensitive to economic cycles, providing more stability.

Can I reinvest preferred dividends automatically?

Some brokerage accounts offer a dividend reinvestment plan (DRIP) that allows investors to reinvest preferred dividends automatically, purchasing more preferred shares. This option can be a convenient way to grow investments over time without manually reinvesting.

Conclusion

Preferred dividends offer investors a steady income and higher priority in payments, making them a valuable choice for those looking for reliable returns. With benefits like predictable payouts and tax advantages, preferred dividends can help balance income and security in an investment portfolio.

Understanding the different types, market trends, and factors that affect preferred dividends allows investors to make smarter choices that fit their financial goals. For those focused on stable income, preferred dividends could be a good addition to consider.
Interested in diversifying further? Check out our Growth Equity Primer.