What Is Cumulative Preferred Stock and Its Key Features?

Preferred stock is a class of ownership distinct from common stock. This equity typically offers advantages to its holders, particularly concerning the distribution of company earnings. Preferred stock is often considered a hybrid security, blending characteristics of both equity and debt instruments. It occupies a specific position in a company’s capital structure, providing a different risk and return profile compared to common shares.

Understanding Preferred Stock

Preferred stock is an equity instrument that provides a fixed dividend rate, paid out at set intervals. This fixed dividend makes preferred stock similar to bonds, offering a predictable income stream to investors. Holders of preferred stock also receive priority over common stockholders when it comes to dividend payments, meaning they must be paid before any dividends can be distributed to common shareholders.

Beyond dividend priority, preferred stockholders also have a higher claim on a company’s assets in the event of liquidation, although their claim is subordinate to that of bondholders and other creditors. Unlike common stock, preferred stock typically does not carry voting rights, limiting the influence preferred shareholders have over company management and decisions. This distinction in rights and the nature of their returns sets preferred stock apart from common stock, which offers variable dividends and potential for capital appreciation, alongside voting privileges.

The Cumulative Feature

The cumulative feature provides significant protection for investors regarding dividend payments. If a company misses a dividend payment to cumulative preferred shareholders, that unpaid dividend accumulates as “dividends in arrears” on the company’s books.

These accumulated unpaid dividends must be paid in full to cumulative preferred shareholders before any dividends can be paid to common shareholders. This means that if a company misses several dividend payments, it must eventually pay all past due amounts, along with the current period’s dividend, to its cumulative preferred stockholders before common shareholders receive anything. For example, if a company owes $5 per share annually and skips payments for two years, it must pay $15 per share ($5 x 3 years) to these shareholders before common dividends can resume. This obligation significantly reduces the dividend risk for investors in cumulative preferred stock.

Dividends in arrears serve as an important financial indicator, often disclosed in a company’s financial statements. While companies are not legally obligated to pay dividends, the cumulative feature ensures that preferred shareholders retain their claim to missed payments. This mechanism provides a layer of security, making cumulative preferred stock a more attractive option for income-focused investors who prioritize steady payouts.

Other Key Characteristics

Beyond their cumulative dividend feature, preferred stocks often have other characteristics. One such characteristic is liquidation preference, meaning that in a company’s dissolution or bankruptcy, preferred shareholders have a claim on the company’s assets before common shareholders. This priority provides a layer of security, placing preferred stockholders higher in the payment hierarchy than common equity holders, though still behind bondholders and other creditors.

Another common feature is the absence of voting rights. Preferred stock does not grant its holders the ability to vote on corporate matters, such as electing board members or major strategic decisions. This contrasts sharply with common stock, which usually provides voting privileges, thereby limiting preferred shareholders’ direct influence over the company’s governance. This lack of voting power is often a trade-off for the preferred treatment in dividends and liquidation.

Many preferred shares also include a callability feature, which grants the issuing company the right to “call” the shares at a predetermined price after a certain date. Companies might exercise this option if interest rates decline, allowing them to refinance at a lower dividend rate, or if they wish to reduce their preferred equity. While less common for cumulative preferred stock, convertibility is another potential feature, allowing preferred shares to be converted into a predetermined number of common shares. This offers a pathway for preferred shareholders to participate in the common stock’s potential for capital appreciation.

Cumulative Versus Non-Cumulative

The distinction between cumulative and non-cumulative preferred stock revolves around the treatment of missed dividend payments. For cumulative preferred stock, any missed dividends accumulate as “dividends in arrears.” These arrearages must be paid in full to cumulative preferred shareholders before any dividends can be distributed to common shareholders. This ensures that preferred shareholders are eventually compensated for any skipped payments, providing a significant safety net for their income stream.

In contrast, non-cumulative preferred stock does not carry this accumulation feature. If a company misses a dividend payment on non-cumulative preferred shares, that payment is lost for the shareholder. The company is under no obligation to make up for past missed dividends before resuming payments to either preferred or common shareholders. This fundamental difference in dividend treatment highlights the additional security and predictability offered by the cumulative feature, making it a more desirable characteristic for many investors seeking consistent income.