Are you considering noncumulative preferred stock but unsure how it works or why it might suit your portfolio? 

This stock offers fixed dividends but doesn’t let investors recover missed payments, unlike cumulative shares. For companies, it’s a flexible way to raise capital, and for investors, it provides steady returns with the risk of missed payments during downturns.

In this article, we’ll break down how noncumulative preferred stock works, compare it to other stock types, and help you understand its benefits and risks.

Decoding Noncumulative Preferred Stock

Noncumulative preferred stock is a type of equity that grants shareholders the right to receive fixed dividends, but with an important distinction: Shareholders of noncumulative preferred stock have no right to claim unpaid dividends if the company misses a dividend payment. Unlike with cumulative preferred stock, unpaid dividends on cumulative preferred stock accumulate and must be paid out before any dividends can be issued to common shareholders, but, with noncumulative preferred stock, noncumulative preferred stockholders forfeit any missed dividends altogether.

Corporate finance uses noncumulative preferred stock as a flexible option. This lets them lure interest without being stubbornly bound to paying out long term dividends. For example, if a company undergoes a stretch where profits decline, it can simply drop dividend payments to its noncumulative preferred shareholders without having to pay back the payments in the future. This gives companies much more financial flexibility, especially in uncertain or volatile economic environments.

Noncumulative preferred stock has advantages and risks for an investor. First, it usually offers a higher dividend rate than common stock (which can make it attractive to income seekers). Secondly, because the missed dividends are not protected, these shares are riskier than those that are cumulative. Without any possibility of recovering these payments later on, investors have to accept the idea that during times of poor company performance, they may receive no, or very little, dividend income.

In general, noncumulative preferred stock offers corporations and investors a hybrid choice between regular income in the form of dividends and the risk of lost dividends. 

Comparison with Cumulative Preferred Stock

The main distinction in terms of noncumulative and cumulative preferred stock is where unpaid dividends go. Preferred stock, cumulative, protects shareholders by accumulating or deferring skipped or deferred dividends that must be paid before dividends are paid to common shareholders. This safety net ensures cumulative preferred shareholders always get paid missed payments and provides more security during a time of financial difficulties.

By contrast, noncumulative preferred stock does not provide this protection. In contrast, if a company withholds a dividend, noncumulative shareholders lose it forever, because there is no way to reclaim unpaid dividends. The payment is lost once it is skipped, so noncumulative preferred stock is riskier. The investors base themselves entirely on the company’s consistent profitability to be assured of the expected income.

There is an important distinction between cumulative and noncumulative preferred stock: noncumulative preferred stock is more tempting to investors who are looking for reliable income and lower risk. However, companies find more flexibility, financially, by issuing noncumulative preferred stock. Companies can skip dividends on noncumulative shares during hard times without creating future liabilities – so that cash flow can be preserved.

The dividend rates differ, too, between these types of stock. They also have the lowest dividends, since the added security comes at the cost of lower dividend. However, noncumulative preferred shares normally pay higher dividends in order to offset the higher risk of missing a payment. This trade-off highlights the central decision for both investors and companies: It’s an issue of balancing income stability with potential returns. 

Equity Characteristics: Common vs. Preferred Stock

Preferred stock that does not accumulate can be viewed as standing between the risk/reward points of common stock and other preferred stock. Noncumulative stock, like other preferred shares, pays fixed dividend payments, which makes it attractive to income focused investors. Plus it has a greater claim on a company’s assets in the event of liquidation than common stock adds another layer of security.

Unlike common stock, preferred shareholders don’t take part in capital appreciation but they do get paid dividends first. Depending on performance, a company’s growth may be reflected in the price of its stock rising, its dividend payments to common stockholders increasing, or its free cash flow yield improving. Preferred shareholders, on the other hand, who are noncumulative, receive fixed returns which cut off their ability to grow from a company’s success beyond the set dividend. This stability appeals to people who want steady cash flow instead of the potential upside, but it limits the upside.

Noncumulative shares have a greater risk than cumulative preferred stock. Preferred stock that accumulates unpaid dividends and which must be paid before any distributions to common shareholders. Shareholders who do not own cumulative stock do not have this protection; missed dividends are forfeited permanently. This increases the risk, but the trade off is often greater income, and noncumulative preferred stock is of interest to investors willing to sacrifice some of the security advantage in return for higher income.

To conclude, noncumulative preferred stock offers more stable income than common stock, but at the cost of being less secure than cumulative preferred stock. It puts investors looking for medium level risk and regular income on a middle ground, but does mean giving up capital appreciation potential. 

Debt Features: Convertible Bonds vs. Preferred Stock

Convertible bonds and noncumulative preferred stock are both combinations of debt and equity, they are very different in structure and what they provide for investors. Corporate debt instruments called convertible bonds offer bondholders the right to convert them into a specific number of the company’s common shares. That renders it possible for people to get the advantage of fixed bond curiosity payments and the potential benefit if the company’s stock price increases in value. In return for the added value of the convertible bonds’ conversion feature, convertible bonds typically have lower interest rates than traditional bonds.

Unlike cumulative preferred stock, noncumulative preferred stock is used more like equity, as it is not considered a debt obligation. Dividends are fixed and paid to shareholders, but missed payments are not accumulated for the future, but forfeited instead. Unlike convertible bonds, noncumulative preferred stock does not allow investors to convert to capitalizing on a rise in stock price. But common shareholders are subordinate to preferred shareholders on both the dividend payments and their claims on assets in the event of liquidation, as seen in cases like Deutsche Bank’s recent liquidation suit against Chinese developer Shimao.

From the standpoint of risk, convertible bonds tend to be less risky than noncumulative preferred stock. They are creditors, so they have a higher claim on company assets even at times of financial trouble. As a result, this also increases the probability of bondholders recovering some of their principal in case of bad company performance. By contrast, noncumulative preferred shareholders face much more uncertainty: they can be promised a dividend payment that is not paid if the company ceases to pay dividends, and are left with nothing if the company becomes financially distressed.

Convertible bonds provide steady debt income yet with potential equity upside; esoteric debt instruments, on the other hand, often offer unique risk-reward profiles tailored to niche markets; and noncumulative preferred stock gives fixed dividends yet with more risk and fewer growth opportunities in hard times.

Real-Life Application

Take for example Ford Motor Company (F) that issued noncumulative preferred stock as a part of its strategy to raise capital when it was in a financially challenging period. The shares paid a fixed 5% dividend, paid quarterly, which made them attractive to income focused investors. However, as noncumulative shares any missed dividend payments wouldn’t be accumulated for future repayment as they are noncumulative shares.

For example, Ford experienced delays in production (and rising costs, falling cash flow) due to semiconductor shortages during the global supply chain disruptions in 2021–2022. The company could have skipped a dividend payment on its noncumulative preferred stock, to conserve resources. That income would have been permanently forfeited to shareholders by the taxes they paid at that time, and there would be no ability to ever recoup that missed payment in future quarters. Even when financial conditions improved to the point where a resumption of dividends was possible, the investors carrying the stock during the skipped payment period would receive no compensation for the lost money.

The issuing preferred stock for the company gave them the flexibility to deal with financial difficulties without the responsibility of repaying missed dividends. However, this strategy helped Ford to control cash flow as a period of crisis proceeds. But for investors, the risk was clear: the stock offered reliable income when things were stable, but it could be suspended when times got tough.

This then allows us to explore a real world example of the tradeoffs one faces with noncumulative preferred stock. Unlike cumulative preferred stock or bonds, its issuance gives companies greater financial flexibility, but investors would lose income in the event of unfavourable economic conditions. 

Advantages of Investing in Noncumulative Preferred Stock 

This type of preferred stock has several advantages that will interest income oriented investors looking for the right balance between risk and returns. It is one of its key advantages—its higher dividend yield versus most other preferred shares and common stock. These shares don’t accumulate missed dividends, which means that companies sometimes compensate for that by offering just a smidge higher dividend rates, which makes them appealing for those looking for a predictable, if not slightly better, income stream.

Moreover, the noncumulative preferred stock rate tends to be less volatile than that of common stock. It’s based on fixed dividend yields, rather than performances of the company or market trends and thus not susceptible to price swings. Conservative investors who don’t like the volatility of the rest of the stock market are attracted to this relative stability.

Tax advantages may also exist with noncumulative preferred stock. Depending on where you live and the tax laws in place, dividends from preferred shares may be taxed at a lower rate than ordinary income in some cases. For income focused investors this favorable tax treatment can boost the overall return.

To sum up, noncumulative preferred stock provides higher dividend yields, priority in payouts, less volatility and offers potential tax benefits making it a suitable investment for those looking for stable income with moderate risk. 

Drawbacks of Noncumulative Preferred Stock 

Noncumulative preferred stock has its advantages, but its disadvantages are too great to ignore. A big disadvantage is the absence of security for missed dividend payments. Noncumulative shareholders lose missed payments, unlike cumulative preferred stock for which unpaid dividends accrue and must be paid before common shareholder payouts. Dividends are the only risk for income reliant investors who are so when companies struggle financially they can skip dividends without any obligation to repay.

A second drawback is an almost zero potential for capital appreciation. Common shareholders benefit from a company’s growth or rising stock price, but noncumulative preferred stockholders do not. They aren’t locked into giving dividends that rise and fall in line with how the company does, rather they’re locked into paying fixed dividends. But this restriction can be a thorn in the side of investors looking to make a safe return and capital gains.

In addition, noncumulative preferred stock also poses higher risks in the economic downtrends. The problem is that companies can withhold dividends from these shares in times of financial stress, making income streams for investors inconsistent or zero. This lack of downside protection makes such shares less attractive for conservative investors who prefer stability, since the result can be quite unpredictable.

Moreover, liquidity of common stock is generally lower than that of noncumulative preferred stock. In volatile markets, preferred shares are generally harder to buy or sell quickly without affecting its price. The lower liquidity can make it harder for investors to adjust their positions in case of market instability and thus add to the overall risk.

Noncumulative preferred stock has the disadvantage of forfeiting missed dividends, having limited growth potential, being vulnerable in downturns, and having lower liquidity. When considering an investment of this type, investors must weigh these risks carefully, potentially supplementing their strategies with tools like real-time trade alerts, which can provide timely updates to help navigate market shifts and mitigate vulnerabilities.

Strategic Implications for Investors

Investors who are looking for stable income at moderate risk, and who are not interested in the volatility of common stock may choose noncumulative preferred stock. The main benefit is a higher dividend yield than common stock or cumulative preferred shares. The extra yield often makes up for the more elevated risk of giving up unpaid dividends, making it an attractive bet for income focused folks.

Furthermore, the priority of dividend distribution makes another strategic appeal. Noncumulative preferred shareholder has a higher claim than a common shareholder, but missed dividends are not recoverable. However, these shares tend to be attractive to those looking for a steady income provided they can take the risk of not receiving any payments during times of stress.

Risk tolerant investors, anxious to trade dividend security for higher yields, are also attracted to noncumulative preferred stock. For instance, those that are confident in the long term stability of a company, in industries with predictable cash flow, like utilities assets or consumer staples may see a low risk of missed dividends, although the higher yields may be worth the trade off.

Noncumulative preferred stock also serves a useful role in diversification. The returns of preferred stock are bond like, but equity like, and thus are well suited for investors who already own a significant amount of common stock or bonds. The middle ground here offers an alternative to create income with a comparatively lower risk profile than what common stock typically has.

In total, investors will take noncumulative preferred stock with greater yields, dividend priority and diversification. Those willing to take the risk of missing out on payments in return for potentially increased income, however, will find this particularly useful. 

Regulatory and Fiscal Considerations 

There are important regulatory and fiscal considerations for companies and investors in the issuance, and trading, of noncumulative preferred stock. From a regulatory point of view companies are required by financial authorities, such as the U.S. Securities and Exchange Commission (SEC), to comply. Documents that offer must disclose key details regarding voting rights, noncumulative features, preferred dividend rate, preferred liquidation preferences. Disclosures are made in order to help potential investors know what the investment will really be and the risks, especially the risk of forfeiting dividends.

Another vital factor is the tax implications. Preferred stock dividends are sometimes considered qualified dividends for investors, who pay a lower rate of tax on this income than ordinary income. But this can be a tax benefit depending on the investor’s jurisdiction, the holding period, and other tax circumstances. Knowledge of these rules helps investors maximize after tax return on their investments.

The advantage of noncumulative preferred stock issuance is that it gives companies greater financial flexibility but it does not allow companies to take a tax deduction for dividend payments as they can when paying interest. The noncumulative characteristic enables firms to suspend dividend payments during bad times, like the economic downturn in France, without the liability buildup characteristic of cumulative preferred stock. Having this type of flexibility is crucial for keeping cash flow during difficult times.

The brokerage and exchange rules are also to be observed for trading in noncumulative preferred stock. In addition, issuers of preferred shares are often required by stock exchanges to meet minimum price levels and to report their financial health so as to make sure that preferred shares meet standards for trading to the public. Such measures serve as a means of protecting investors from depositors by ensuring transparency and stability of the market.

Overall, noncumulative preferred stock plays out as a regulatory and tax consideration that profoundly influences the issuance and trading of the stock, and these considerations are factors taken into account by investors and corporate strategy. 

Conclusion

The combination of fixed dividend payment and corporate financial flexibility is unique to noncumulative preferred stock. Higher dividend yields and the fact that they’re paid prior to common shareholders are appealing, but they come at the risk that investors lose the dividends if the company skips payments. But this makes it a good choice for income focused investors willing to take a bit of risk for the chance of greater returns.

From a corporate point of view, noncumulative preferred stock allows for capital raising without giving up control over dividend payments when things are tough. This flexibility allows for management of the cash flow without the long term commitment of the cumulative preferred shares. But that comes with the risk of missing income during economic uncertainty.

In the end, noncumulative preferred stock is a compromise between common stock and debt: it has no risk of default but its value is not protected against fundamental fluctuations in the company. These shares should be used by investors to align with their specific financial goals, their risk tolerance and the performance of the issuing company. 

Understand Noncumulative Preferred Stock: FAQs

What Makes Noncumulative Preferred Stock Different from Cumulative Preferred Stock?

The biggest difference between cumulative and noncumulative preferred stock is that it treats missed dividend payments differently. In preferred stock that is cumulative, if the company does miss a dividend, the unpaid dividends accumulate and must be paid in full before there is any dividend payment to common shareholders. On the other hand, if a dividend is missed with a non cumulative preferred stock, it is forfeited and not paid in the future.

How Does Nonpayment of Dividends Affect Noncumulative Preferred Stock?

Noncumulative preferred stock dividends are paid to company shareholders, but if a company opts not to pay, shareholders forfeit any right to future payment. Because noncumulative preferred stock does not have the right to forbear unpaid dividends, this feature can make the stock less attractive than cumulative preferred stock in the event of financial distress because missed dividends cannot be recovered, while unpaid dividends for cumulative preferred stock must be paid prior to any other.

Are There Specific Sectors or Industries Where Noncumulative Preferred Stock is More Common?

Issuance of noncumulative preferred stock is more often observed in industries with reasonably predictable cash flows but the possibility of cash flow problems, including financial services and utilities, where metrics like price to cash flow are often closely monitored. However, these industries may choose noncumulative shares in order to give themselves more latitude during downturns without incurring large dividend liabilities.

What are the Tax Implications of Investing in Noncumulative Preferred Stock?

Dividends on noncumulative preferred stock are typically treated as qualified dividends and may be taxed at a lower rate than ordinary income depending on the jurisdiction thereof and holding period. But the tax consequences of dividends will differ, and investors should consult with tax professionals as to how their dividend income will be taxed.

Can Noncumulative Preferred Stock Be Converted Into Common Stock?

Convertible preferred stock, if so designated, can be converted into common stock and is noncumulative. It permits shareholders to trade their preferred shares for a specified number of common shares and perhaps achieve capital appreciation after tax. A noncumulative preferred stock is not convertible for common stock if it is not convertible.