Do Preferred Shares Always Pay Dividends?

When you think of preferred shares, the notion of a steady, reliable income stream from dividends often springs to mind. But is it always the case that preferred shares pay dividends? The reality is more nuanced and understanding it requires a dive into the mechanics of preferred shares and the conditions under which dividends might—or might not—be paid.

The Basics of Preferred Shares

Preferred shares, or preferred stock, represent ownership in a company, but unlike common shares, they come with specific privileges and risks. Typically, preferred shareholders receive dividends before common shareholders, which makes them an attractive investment for those seeking regular income.

Dividend Payments: The Default Expectation

For many investors, the primary allure of preferred shares is the promised dividends. These dividends are usually fixed and are stated as a percentage of the par value of the shares. In many cases, preferred shares have a cumulative dividend feature, meaning that if a company fails to pay dividends in a given period, it must make up for those missed payments before any dividends can be distributed to common shareholders.

Non-Cumulative Preferred Shares

However, not all preferred shares are created equal. Non-cumulative preferred shares do not have this feature. If a company skips a dividend payment on these shares, the missed payment does not accumulate. This means that preferred shareholders of non-cumulative shares have no right to claim unpaid dividends in the future. Essentially, once a dividend payment is missed, it is lost permanently.

The Impact of Company Financial Health

The ability and willingness of a company to pay dividends on preferred shares largely depend on its financial health. In times of economic downturns or financial strain, companies might prioritize conserving cash and might suspend dividends on preferred shares to preserve liquidity. This is especially common with non-cumulative preferred shares where missed payments cannot be reclaimed.

Preferred Shares: A Double-Edged Sword?

Investing in preferred shares involves balancing the appeal of regular dividends with the risk of non-payment. Here’s a closer look at why preferred shares might not always pay dividends:

1. Financial Distress: Companies in financial trouble may cut or suspend dividends to improve their cash flow. While preferred shareholders are prioritized over common shareholders for dividends, they are still subordinate to bondholders in terms of financial claims.

2. Dividend Policy Changes: Even if a company is financially healthy, it may decide to change its dividend policy, affecting the payments to preferred shareholders. This could be due to strategic decisions or changing financial goals.

3. Business Performance: Companies that are experiencing significant growth may reinvest profits into the business rather than paying out dividends. While this could benefit shareholders in the long run through increased stock value, it means that current dividends may be reduced or suspended.

How to Navigate the Risks

To mitigate the risks associated with preferred shares, consider the following strategies:

• Research the Issuer: Before investing, thoroughly research the issuing company’s financial health and dividend history. Understanding the issuer’s stability can provide insights into the likelihood of continued dividend payments.

• Understand the Terms: Know whether the preferred shares you are investing in are cumulative or non-cumulative. This knowledge is crucial in assessing the risk associated with missed dividends.

• Diversify Investments: Don’t put all your eggs in one basket. Diversify your investments across different asset classes and companies to spread risk.

• Stay Informed: Keep up with the company’s financial reports and market conditions. Changes in the business environment or financial status can impact dividend payments.

Real-World Examples

Let’s explore some examples to illustrate these points:

Example 1: A Cumulative Preferred Share

Suppose Company A issues cumulative preferred shares with a 5% dividend rate. In a year of financial strain, Company A decides to suspend dividend payments. The next year, the company recovers and resumes payments. As per the cumulative feature, Company A will need to pay the missed dividends from the previous year before paying any new dividends. This ensures that investors receive the full amount owed.

Example 2: A Non-Cumulative Preferred Share

Conversely, Company B issues non-cumulative preferred shares with a similar 5% dividend rate. During a challenging financial period, Company B suspends dividend payments. Unlike Company A, Company B is not obligated to pay the missed dividends in the future. Preferred shareholders of Company B will not see any compensation for the missed payments.

Conclusion

While preferred shares are often associated with reliable dividend payments, they do not always guarantee them. Factors such as the type of preferred shares, the financial health of the issuing company, and broader economic conditions play a crucial role in determining whether dividends will be paid. Understanding these elements can help investors make informed decisions and manage their expectations regarding dividend income from preferred shares.