Preferred Dividends: How They Work and Why They Matter

Want dividends you can count on no matter how the market moves?

Preferred dividends are fixed payments to preferred shareholders that come before any common stock payouts. They offer steady, bond-like income with some stock upside, helping smooth returns and add portfolio stability. Companies commit to a set dividend rate, making them dependable even in volatile markets.

While they may not deliver the biggest growth, their consistency makes them a smart choice for generating income, lowering risk, and diversifying a dividend strategy.

What you’ll learn

• Preferred Dividends Explained
• How Preferred Shares Work
• Preferred vs. Common Dividends
• Benefits
• Risks and Limitations
• Tax Treatment and Portfolio Placement
• Strategic Use
• Preferred Dividend Opportunities
• Conclusion
• FAQs

Breaking Down Preferred Dividends

Preferred dividends are the payments made to the owners of the preferred shares, which is a security in the capital structure of a firm that is between common stock and bonds in terms of capital structure. These dividends are normally determined and paid at a regular period, irrespective of the changes in earnings. Preferred dividends rank in priority over all other dividends and must be paid prior to any dividend being paid to common stockholders, as compared to common dividends, which can vary or be canceled.

This kind of prioritization is appealing to investors who would want to get a stable flow of revenue. Cumulative preferred stock adds yet another degree of dependability since any late payments have to be repaid in full before the common shareholders are entitled to dividends.

Preferred shares do not, in most cases, carry voting rights but are usually less volatile than common stock. They have bond-like characteristics due to their fixed-dividend structure and are particularly sensitive to interest rates—an important consideration at a time when another Bank of England rate cut this year appears less likely amid inflation concerns and a divided vote. They therefore offer the yield properties of fixed-income investments while maintaining the liquidity and equity exposure of stocks.

Such characteristics are the reason why dividend strategies are frequently pegged to preferred dividends. They are more reliable than typical dividends, can be used to control cash flow and reduce volatility within a portfolio and to diversify portfolio exposure to the equity markets.

How Preferred Shares Work With Dividend Payments

Preferred dividends have a degree of stability that makes them different as compared to common dividends. In case a company has issued preferred shares, it is normally obliged to pay a set dividend at fixed intervals of time, usually at a quarterly basis. This is a fixed rate when issued and is not adjusted based on earnings which makes it a predictable revenue stream. Payments are prioritized, and the preferred obligations have to be satisfied first before any dividend is paid to the common shareholders.

One of them is whether the stock is cumulative or non-cumulative. Cumulative preferred shares entail that all defaulted payments must be recovered first before the common shareholders get their dividends hence providing extra security in economically strained times. The unpaid dividends are forfeited on non-cumulative shares in case a dividend is not paid which makes the income riskier even though other advantages may also be available.

Another factor is the callability of preferred stock. The issuer can buy back these shares at a fixed price after a certain date having provided the company with flexibility whilst limiting the potential upside of the investment should it be called when the interest rates are low or dividend costs are no longer attractive.

Altogether, preferred shares act as an income contractual vehicle in the equity structure of a company. Their reliable distributions and payment seniority make them a strong choice for traders and investors seeking steady cash flow, similar to other equities known for generating regular dividend income, rather than relying solely on capital appreciation.

Preferred vs. Common Dividends—What Sets Them Apart

The characteristic features of preferred dividends are their predictability and seniority. They must be paid by the company at a specific rate prior to any type of distribution to the common shareholders so a preferred holder will usually be paid on a timely basis and at the full amount, even in the face of fluctuations in short term earnings. This is a huge attraction to the income-oriented investor.

On the contrary, common dividends are variable. They may increase when the business is doing well but may be cut or be put on hold during rough periods. The payment to common shareholders comes after those of preferred holders and as such, the payments are more susceptible to the performance of the company and its economic environment.

Rights and possible returns are also different in the two. They possess the right to price appreciation and most times, common shareholders have voting rights in corporate decisions. Preferred shareholders are usually non-voting and enjoy less capital gains like bondholders as they are more concerned with a constant flow of income rather than growth.

They are also divided by volatility. Preferred shares generally experience smaller price swings than common stock, offering stability during turbulent markets. This can be an advantage when focusing on strong, low-volatility stocks that may hold up well if market conditions become unsettled in the coming months. However, such stability also limits participation in a company’s growth. The choice between the two depends on whether an investor values income stability or is willing to take on more risk for higher returns.

Benefits of Preferred Dividends for Income Stability

The stability that is offered by preferred dividends is attractive to most traders and investors particularly in fluctuating markets. They are usually fixed in terms of the rate of payment and are paid regularly, and provide predictable income like a bond interest. This stability can enhance a diversified income plan, providing exposure to an equity based market, but without the complete risk accompanying common stock.

One of the most important strengths is that they enjoy precedence in the capital structure. The preferred shareholders receive payment ahead of the common shareholders so that firms have a higher likelihood of sustaining these payments even in cases where the firms reduce or reinstate common dividends. This senior position in the capital structure provides further security to those that are concerned with reliability.

Preferred shares are also less prone to fluctuation in prices as compared to common stocks, and they help to maintain capital and achieve dividend yield. This is because their consistent dividends may be used to absorb portfolio losses and keep cash flow in a market decline.

Although the preferred shares do not usually have growth potential as common stock, they offer the benefit of generating stable income, with lower risk and thus provide a beneficial means of balancing performance. This juxtaposition of stability, consistency and priority is a good reason as to why preferred dividends are a good bet among those traders and conservative investors who are more interested in earning income.

Risks and Limitations of Preferred Stocks

Preferred stock has the benefit of consistent income and certain downside protection, but with trade-offs investors need to take into account. The most striking one is modest price appreciation. In contrast to common stock, which would gain tremendously with the success of a firm, preferred shares tend to move in a limited band, and therefore they are not attractive to growth-oriented strategies.

They are interest-rate sensitive too. Since the amount of preferred dividends is predetermined, they tend to lose market value if rates rise, much like bonds. New preferred issues may offer higher yields, making existing ones less attractive and pushing their prices down—especially during periods of tightening monetary policy, as seen in recent calls from the U.S. Treasury for the Bank of Japan to continue raising rates.

The other disadvantage is the lack of voting rights, which reduces the ability of the shareholders in decision making that can either affect long-term value or the sustainability of the dividends. To some people this lack of control can be a fair price to pay in exchange for secure income, to others it can be a drawback.

Finally, the desirability of preferred stocks is based on income objectives, in addition to market circumstances. They are able to generate returns in low rate or volatile environments. However, their drawbacks are more evident in rising-rate cycles or among those investors who intend to achieve considerable growth. One should make a careful assessment of these factors prior to investing in preferred shares.

Tax Treatment and Portfolio Placement

Preferred dividends are taxed differently based on whether or not they are qualified or non-qualified. The rate of taxation of qualified dividends is the long-term capital gains rate, which is 0%, 15%, or 20% depending on income. Dividends must be paid by either a U.S. corporation or a qualified foreign corporation and investors must have a specific holding period in order to qualify.

Most of the preferred stocks (particularly those of financial institutions or REITs) are paying non-qualified dividends. These are levied at the rate of ordinary income of the investor which may be very high. This difference has the potential to cause a large impact on net returns among high-income investors. Short-term traders are further affected because capital gains on short-term trades are considered ordinary income unless the requirements to meet holding periods are attained.

Due to the nature of these tax considerations, preferred stocks tend to perform well in tax-advantageous investments such as an IRA or 401(k). The preservation of such accounts by holding them protects the investor against direct taxation of non-qualified dividends so that the income will accumulate tax-deferred or in some cases tax-free, depending on the type of account held.

Portfolio placement can enhance the long-term results. Investors can also shelter more of the stable cash flow that income-oriented investments such as preferred shares generated by holding the securities in tax-efficient accounts, thereby minimizing the taxation effect on the total performance.

Strategic Use in Day and Swing Trading

As much as preferred stocks may be regarded as a long-term income, it is also an instrument that can be used in short-term trading strategies. The fact that their price is relatively stable in comparison to that of common stocks is a cushion in a volatile market and they can therefore be used by day and swing traders who are in need of a hedge against more risky trades.

Preferred shares can also provide a steady, predictable dividend to assist in cash flow smoothing by traders who are trading to generate income. They do not offer any dramatic price action, but can offer consistent returns in the situations where capital preservation is the primary concern. That is why they are useful in a choppy market where preferreds can be used to counter the volatility of other more speculative positions.

Liquidity is limited. Most of the issues that are preferred have limited liquidity hence increased bid-ask spreads and slippage during rapid trading. Timing and execution becomes very important. A stock’s average trading volume and spreads should be checked by traders to determine which stocks to use in short term rotations.

Preferred stocks are not the primary vehicle for aggressive short-term plays but can serve as a supporting instrument in tactical trading. They may generate dividend income during market lulls or act as a temporary safe haven when risk appetites change. Taken judiciously, and with insights from well-regarded investment newsletters, they can offer stability and flexibility without compromising income potential.

Where to Find Preferred Dividend Opportunities

There are numerous tools that traders and investors can use to identify preferred dividend opportunities. Most large brokerages—such as Fidelity, Charles Schwab, and TD Ameritrade—offer stock screeners that filter by yield, credit rating, callability, and dividend frequency. Alongside other stock picking services, these tools provide a strong starting point for deeper research, helping narrow choices based on income targets or risk tolerance.

There are websites that offer extensive information on dividend schedules, dividend payout ratios, and ex-dividend dates, and may alert users to potential opportunities or policy changes. This can be especially useful for those employing a dividend capture strategy, where timing purchases and sales around ex-dividend dates is key. Morningstar and Seeking Alpha add analyst commentary, ratings, and financial health data to help assess a company’s ability to sustain its payouts.

ETFs tracking preferred stock also can be used as a source of research, including iShares Preferred and Income Securities ETF (PFF) and Invesco Preferred ETF (PGX). Their published holdings provide ready-made lists of liquid, dividend-paying shares in which to do further research.

In assessing opportunities, it is best to look at the financial strength of the issuer as well as the terms of the preferred stock. Other factors such as call dates, cumulative status and yield-to-call could be very important and can also fit into a strategy. Technical screening tools combined with the use of fundamental analysis makes the choices in time, financially viable, and according to the income or risk goals.

Conclusion

The preferred dividends give stable income that is less volatile as compared to common stocks. They are supported by regular payments and a superior place in line of claims and can bring consistent cash flows in volatile markets, which attracts income-oriented portfolios.

Such characteristics are the reason why dividend strategies are frequently pegged to preferred dividends. They are more reliable than typical dividends, can be used to control cash flow, reduce portfolio volatility, and diversify equity exposure. They also fit neatly into valuation methods such as the dividend discount model, which bases a stock’s worth on the present value of its expected dividend payments.

Investors seeking to use preferred shares to gain lower-risk yield or to hedge can find consistency and opportunity when combining them with the correct research and approach.

About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.