Preferred dividends are an important concept to understand when it comes to investing in the stock market. While most investors are familiar with common dividends, which are typically paid out on a regular basis to shareholders, preferred dividends offer a different set of characteristics and benefits. In this post, we will provide an overview of preferred dividends, how they work, and why they may be attractive to certain investors.
What are Preferred Dividends?
Preferred dividends represent a fixed payment made by a company to its preferred shareholders. Unlike common shareholders who have voting rights and participate in the company’s growth through capital appreciation, preferred shareholders receive priority over common shareholders when it comes to receiving dividend payments. These payments are usually made at regular intervals such as quarterly or annually.
Preferred shares themselves have some unique features compared to common shares. They often carry a fixed dividend rate expressed as a percentage of the par value (the original price per share). This means that regardless of the company’s financial performance or profitability, preferred shareholders will receive their fixed dividend payment.
In addition, if the company faces bankruptcy or liquidation, preferred shareholders have higher priority than common shareholders when it comes to receiving their investment back. However, unlike bondholders who have legal claims on assets in case of bankruptcy proceedings, there is no guarantee that preferred shareholders will recover their initial investment.
Types of Preferred Shares
There are several types of preferred shares available for investors:
1. Cumulative Preferred Shares: With cumulative preference shares, if the company fails to pay dividends during a particular period due to financial constraints, those unpaid amounts accumulate and must be paid out before any distributions can be made to common shareholders.
2. Non-Cumulative Preferred Shares: Non-cumulative preference shares do not accumulate unpaid dividends but instead only entitle holders to receive current dividend payments.
3. Convertible Preferred Shares: Convertible preference shares give holders the option to convert their shares into common stock after a predetermined period or under specific conditions.
4. Callable Preferred Shares: Callable preference shares give the company the right to redeem or buy back the shares at a predetermined price after a specified period.
Advantages of Preferred Dividends
Preferred dividends can be appealing to certain types of investors due to several advantages:
1. Fixed Income Stream: The fixed dividend payment provides stability for income-oriented investors who seek a regular cash flow instead of relying on potential capital gains from common stock.
2. Priority in Distributions: In case of financial difficulties, preferred shareholders have priority over common shareholders when it comes to receiving dividend payments or recovering their investment during liquidation.
3. Potential Capital Appreciation: Although preferred stocks are not known for significant capital appreciation, they can still experience price increases if interest rates decline or if the company improves its financial position and creditworthiness.
4. Lower Volatility than Common Stock: Preferred shares generally exhibit lower price volatility compared to common stock, making them attractive for conservative investors seeking more stable investment options.
Risks and Considerations
While preferred dividends offer advantages, there are also risks and considerations that investors should keep in mind:
1. Interest Rate Sensitivity: Changes in interest rates can impact the value of preferred shares. When interest rates rise, the value of existing fixed-income investments tends to decrease as newer issues offer higher yields.
2. Limited Growth Potential: Unlike common stockholders who may benefit from an increase in share prices, preferred shareholders do not typically participate in a company’s growth through capital appreciation.
3. Credit Risk: Investors should assess the creditworthiness and financial stability of companies issuing preferred shares since missed dividend payments could lead to losses or reduced income streams.
4. Lack of Voting Rights: Preferred shareholders usually do not have voting rights unless specifically stated in the terms issued by the company — this means limited influence over corporate decisions compared to common shareholders.
Conclusion
Preferred dividends provide investors with an alternative investment option that offers stability, fixed income, and priority in receiving distributions. They can be particularly attractive for income-oriented investors seeking regular cash flow and lower volatility compared to common stock. However, it’s crucial to carefully assess the creditworthiness of companies issuing preferred shares and consider their unique characteristics before investing. As always, consulting with a financial advisor or doing thorough research is recommended when considering any investment decision.