Preferred dividends are payments made to owners of preferred stock before any money goes to common shareholders
When a company earns profit and decides to distribute it to shareholders, preferred dividends get paid first. If you own preferred stock, you receive your dividend payment before the company pays anything to people who own common stock. This priority is written into the terms of the preferred stock when it is issued — it is not something that changes based on how well the company performs in any given year.
The amount of a preferred dividend is usually fixed. A preferred share might pay 5% of its stated value each year, or a specific dollar amount per share, regardless of whether company profits go up or down. This makes preferred dividends different from common dividends, which fluctuate based on company performance and board decisions.
Preferred stock sits between bonds and common stock in terms of risk and return. You get more certainty than a common shareholder but less safety than a bondholder. If the company runs into trouble, preferred shareholders get paid before common shareholders, but after creditors and bondholders.
Key Takeaways
- Preferred dividends are paid before common dividends, and the amount is usually set when the stock is issued.
- Most preferred dividends are fixed payments, so they do not change when company profits rise or fall.
- If a company cannot afford to pay preferred dividends, they typically cannot pay common dividends either, and the unpaid amount may accumulate.
- Preferred stock is riskier than bonds but safer than common stock if the company faces financial trouble.
- Some preferred stock is cumulative, meaning unpaid dividends build up and must be paid before common shareholders receive anything.
How preferred dividends differ from common dividends
Common dividends are discretionary — the board of directors decides each quarter or year whether to pay them, how much to pay, and to whom. In a strong year, common shareholders might receive a large dividend. In a weak year, they might receive nothing. The company has no obligation to pay common dividends.
Preferred dividends operate under a contract. The terms are set when the preferred stock is issued, and the company is expected to honor them. If the company skips a preferred dividend, it is a serious breach that can trigger legal action or restrictions on the company's ability to pay common dividends or take on new debt.
Because preferred dividends are more reliable, preferred stock typically pays a lower rate than common stock would in a good year. You trade upside potential for downside protection.
Cumulative versus non-cumulative preferred dividends
Most preferred stock is cumulative, which means if the company cannot pay the dividend in one period, the unpaid amount does not disappear. It accumulates and must be paid in full before the company can pay any common dividend. If a company skips three quarterly preferred dividends, all three must be paid before a single penny goes to common shareholders.
Some preferred stock is non-cumulative, which is rarer and less favorable to the preferred shareholder. If the company skips a dividend payment, that payment is simply lost — it does not carry forward. The company only owes the current period's dividend going forward.
When you buy preferred stock, the prospectus or offering document will state whether it is cumulative or non-cumulative. Cumulative preferred stock is generally worth more because the missed payments create a larger obligation that must be settled before common shareholders benefit.
What happens when a company cannot pay preferred dividends
If a company faces financial hardship and cannot pay preferred dividends, the consequences depend on the terms of the stock and the company's situation. In many cases, the company is also prohibited from paying common dividends or buying back its own stock until preferred dividends are current.
Preferred shareholders may have voting rights that activate if dividends are missed. For example, if preferred dividends are unpaid for two quarters, preferred shareholders might gain the right to elect one or more board members. This gives them a seat at the table to push for a recovery plan.
If the company enters bankruptcy, preferred shareholders stand ahead of common shareholders in the line to recover their money, but behind secured creditors and bondholders. The order of payment is: secured creditors, then unsecured creditors and bondholders, then preferred shareholders, then common shareholders.
Participating versus non-participating preferred dividends
Most preferred stock is non-participating, meaning you receive only the fixed dividend stated in the terms. You do not share in any extra profits the company makes beyond that.
Participating preferred stock is less common but more valuable. It allows you to receive your fixed preferred dividend and then also participate in common dividends alongside common shareholders, or receive a share of profits above a certain threshold. This is typically found in venture capital and private equity deals rather than public company stock.
When you research a preferred stock, the prospectus will clearly state whether it is participating or non-participating. Participating preferred stock usually trades at a higher price because it offers both downside protection and upside potential.
Callable preferred stock and dividend risk
Many preferred stocks are callable, which means the company can buy back the shares at a set price after a certain date. This creates a hidden risk for preferred shareholders.
If interest rates fall, the company can call in the preferred stock and issue new preferred stock at a lower dividend rate. You lose the higher dividend payment you were counting on. Conversely, if interest rates rise, the company will not call the stock, and you are stuck with a below-market dividend rate.
Callable preferred stock typically pays a slightly higher dividend to compensate for this risk. When comparing preferred stocks, check the call date and call price — they affect the real return you can expect.
Tax treatment of preferred dividends
In the United States, preferred dividends received by individuals are usually taxed as ordinary income, not at the lower capital gains rate. This is different from common dividends, which often may have access to for preferential tax treatment if held for a certain period.
The tax treatment can vary depending on the type of preferred stock and your holding period. Preferred stock issued by certain financial institutions or held in specific structures may receive different tax treatment. You should review the tax implications with a tax professional before investing, because the after-tax return is what matters to your actual wealth.
Frequently Asked Questions
Do I have to receive a preferred dividend if the company makes a profit?
Yes, if the preferred stock is cumulative. The company must pay the stated preferred dividend before paying common dividends or buying back stock. If the company skips the payment, it accumulates and must be paid later. Non-cumulative preferred stock has no such may provide, but this type is rare in public markets.
What happens to my preferred dividend if the company is acquired?
The acquiring company typically assumes the preferred stock and continues paying dividends under the original terms. However, the acquisition agreement may include a provision to redeem the preferred stock at a set price. Review the acquisition announcement to see whether preferred shares are being redeemed or assumed.
Can a company cut my preferred dividend?
No, not unilaterally. The dividend rate is set in the stock's terms and cannot be changed without shareholder consent or a restructuring. If the company faces severe financial distress, it may propose to modify the preferred terms, but this requires a vote and typically triggers legal protections for preferred shareholders.
Is preferred stock safer than bonds?
No. Bonds are senior to preferred stock in bankruptcy, meaning bondholders get paid before preferred shareholders. Preferred stock is riskier than bonds but safer than common stock. If you want maximum safety, bonds are the better choice.
Why would I buy preferred stock instead of common stock?
Preferred stock offers a fixed, predictable income stream and priority in bankruptcy. Common stock offers the potential for larger gains if the company grows. Preferred stock is better for income-focused investors; common stock is better for growth-focused investors.