What Are Preferred Dividends?

Preferred dividends are payments made to holders of preferred stock , a type of equity that combines features of both stocks and bonds. These dividends are typically fixed and paid out regularly, often on a quarterly basis. Unlike common stock dividends, preferred dividends must be paid before any dividends are issued to common stockholders, making them a more secure investment. Additionally, they are usually cumulative, meaning if a company skips a dividend payment, it must make up for it in the future before paying common stock dividends. While preferred dividends offer stability, they generally do not provide the same potential for capital appreciation as common stocks. Instead, investors choose preferred dividends for their predictable returns and priority over common stock in the event of a company liquidation.

If you need help picking investments, a financial advisor can guide you in creating an investment plan.

How Preferred Dividends Work

Preferred dividends are paid to investors who hold preferred stock, which is a hybrid financial investment that offers elements of both equity and debt. Companies issue preferred stock to raise capital while committing to regular dividend payments to investors.

These dividends are typically fixed, making them more predictable compared to common stock dividends . Preferred dividends are often paid quarterly and must be distributed before any dividends can be issued to common stockholders . This provides a layer of security for investors, making preferred stock an attractive option for those seeking reliable income.

The payment structure of preferred dividends includes cumulative dividends . If a company is unable to pay dividends at any point, these missed payments accumulate and must be paid out before any future dividends are distributed to common stockholders. This ensures that preferred stockholders receive their due payments, even if the company faces financial difficulties.

Non-cumulative preferred stock exists but is less common. In this case, missed dividends do not accumulate, and the investor forfeits the missed payments.

Preferred dividends also play a significant role in the event of a company’s liquidation. In such scenarios, preferred stockholders have a higher claim on the company’s assets than common stockholders, though they are subordinate to bondholders.

This preferential treatment in both dividends and liquidation proceeds highlights the unique positioning of preferred stock as a relatively safer investment. However, this safety comes at the cost of limited capital appreciation potential - unlike common stock, preferred stock generally does not benefit significantly from the company’s growth and increased market value. Investors choose preferred stock primarily for its steady income stream and reduced risk profile.

How to Calculate a Preferred Dividend

Calculating a preferred dividend involves a straightforward formula based on the preferred stock’s dividend rate and its par value. The par value is the nominal or face value of the stock , typically set when the stock is issued. Meanwhile, the dividend rate is usually expressed as a percentage of this par value.

To find the annual preferred dividend , multiply the par value by the dividend rate. For example, if a preferred stock has a par value of $100 and a dividend rate of 5%, the annual dividend per share would be $5.

Once the annual dividend is determined, calculating the periodic dividend payments depends on the frequency of the payments, which is usually quarterly. To find the quarterly dividend, divide the annual dividend by the number of payment periods in a year. Continuing the previous example, dividing the $5 annual dividend by four quarters results in a quarterly dividend payment of $1.25 per share.

It’s essential for investors to understand that the stated dividend rate is fixed and does not change with the company’s financial performance, providing a stable and predictable income stream. However, if the company fails to declare dividends, cumulative preferred stock ensures that missed payments accumulate and must be paid before any dividends can be distributed to common stockholders.

Preferred Dividends in Arrears

Preferred dividends in arrears refer to unpaid dividends that accumulate when a company is unable or opts not to make scheduled payments.

This situation typically arises with cumulative preferred stock, where any missed dividends must be paid out before any common stock dividends can be issued. If a company skips a dividend payment due to financial constraints, the unpaid amount accumulates and is recorded in arrears. For investors holding cumulative preferred stock, this ensures that they will eventually receive all missed payments once the company’s financial situation improves.

In contrast, non-cumulative preferred dividends do not offer this same protection. If a company cannot pay dividends on non-cumulative preferred stock, those missed payments are forfeited and do not accumulate. This means that investors with non-cumulative preferred stock are at a higher risk of losing out on expected income if the company faces financial difficulties.

Understanding the difference between cumulative and non-cumulative preferred dividends is crucial for investors looking to secure a steady income stream. When dividends are in arrears, they must be paid in full before any dividends can be distributed to common stockholders. This prioritization protects preferred stockholders, ensuring they receive their due payments first.

For example, if a company has $1 million in cumulative preferred dividends in arrears, it cannot pay any dividends to common stockholders until this $1 million is fully paid out. This aspect makes cumulative preferred stock a more secure investment compared to common stock or non-cumulative preferred stock.

Benefits of Preferred Dividends

Preferred dividends offer several advantages for investors, including:

• Priority of payment. Preferred stockholders receive their dividends before any payments are made to common stockholders. This creates a more reliable income stream, especially during times when a company’s profits are limited.
• Fixed dividend rate. Unlike common stock dividends, which can fluctuate based on the company’s performance, preferred dividends are typically fixed at a specific rate. This fixed rate is often higher than the dividend yield of common stock.
• Cumulative dividend feature. Many preferred stocks come with a cumulative dividend feature, which adds an extra layer of protection for investors. If a company is unable to pay dividends at any time, these missed payments accumulate and must be paid out in the future before any common stock dividends can be issued.

Bottom Line

Preferred dividends offer a unique blend of security and predictability, making them an attractive option for income-focused investors. With their fixed dividend rates and priority over common stock dividends, they can provide a reliable income stream. The cumulative feature further enhances their appeal by ensuring that any missed payments are eventually made up, offering an extra layer of financial protection.

Tips for Investment Planning

• Before proceeding, explore all other financial options and seek guidance from a financial advisor to ensure that a hardship withdrawal is the most prudent choice for your situation. Finding a financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to know how much your investments could grow over time, SmartAsset's investment calculator can help you get an estimate for your portfolio.

Photo credit: ©iStock.com/FS-Stock, ©iStock.com/NazariyKarkhut, ©iStock.com/Prostock-Studio

The post What Are Preferred Dividends? appeared first on SmartReads by SmartAsset .