Cumulative Vs. Non-Cumulative Preferred Stock

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Includes: DFP, FFC, FLC, FPE, FPF, HPF, HPI, HPS, IPFF, JPC, JPI, JPS, LDP, PDT, PFD, PFF, PFO, PFXF, PGF, PGX, PSF, PSK, SPFF, VRP
by: Arbitrage Trader

Summary

The word "cumulative" adds too little compared to what many investors believe.

Cumulative in no way means safer.

A lot of investors would say "if not cumulative I am not interested".

There is a real debate in the comments section of my articles and in some of the other articles that I read here on Seeking Alpha. I never realized that people are so concerned about the cumulative feature of preferred stocks. In fact this debate is really funny, because for the income investor this clause should mean absolutely nothing. I understand that this sounds too strange for a big part of the readers and I will appreciate the discussion, but let's look at the facts first.

Cumulative dividend is a sector thing.

A lot of people who prefer cumulative stocks have to realize that this clause is typical for certain sectors and has nothing to do with the specific preferred stock. The two biggest groups of preferred stocks are the REIT preferred stocks and the bank and insurance ones. There are nearly 150 preferreds stocks in each of those two sectors. All REIT preferred stocks are cumulative and at least 90% of the bank and insurance ones are non-cumulative:

source: author's database.

The reason for this is hidden in the way those two types of companies distribute their earnings. REITs are distributing almost all of their income while banks would usually use this income to increase their capital ratios and reduce their risk profile. This leaves the bank preferred stock with a bigger buffer for hard periods. A typical bank will be like a bear that gains weight in the good periods so it can survive the winter without any gains. This weight gaining ability is taken away from REITs by law. They have to compensate for this by offering cumulative dividends. Basically when saying that you prefer cumulative vs. non-cumulative, you just prefer REITs vs. banks. Another sector that is 100% cumulative is the energy sector which leads me to the next important thing any investor should realize.

Cumulative does not mean safer.

If a company has a problem that affects preferred stock, a cumulative preferred stock will not outperform a non-cumulative one. A fast look at the 52 week lows in the energy sector preferred stocks easily proves this fact. There are some preferreds that are not among us anymore and they are not part of the discussion. The important ones are those that will survive. They all fell as low as the financial preferreds in 2008. When a company is in a serious problem even the bonds fall and no one cares about the dividend being cumulative. When you hold a preferred stock bought at $25 that is currently trading at $4, you have to realize that the cumulative clause did not save you. And if for any reason this company survives and the preferred stock starts trading near par again, the cumulative clause is the last reason for that.

So when does cumulative mean something?

The only time when a person should consider the cumulative clause is when it has actually accumulated something. The accumulated dividend significantly raises the internal rate of return for preferreds that trade very close to $0. In my career which is just 8 years so far, I cannot point a single surviving common stock that has outperformed a distressed cumulative preferred stock trading close to $0. One of my favorite strategies is to buy distressed cumulative preferred stocks vs. their common stocks short. This is clearly seen in my articles, but this strategy is totally different from buying a preferred stock close to par, because it is cumulative and therefore safer.

A contrarian thinking.

Let's imagine that an investment grade bank issues a cumulative preferred stock. The first thing I would ask myself is " What is wrong with this bank"? I would personally stay away from this cumulative preferred stock. Why would a bank do that when all other banks are not doing it. Now Let's imagine a REIT that is issuing a non-cumulative preferred stock. What a bold move. I am not sure if this is possible for a REIT, but if this ever happens in the future I am sure that this stock will be very well accepted by the public and this will probably be the safest one in the REIT sector even though it is not cumulative.

Some statistics.

The average current yield for the bank and insurance sector preferreds is 6.3% while this yield for REIT preferreds is around 7.3%. The average current yield for the energy sector preferred stocks cannot be calculated because most of them are suspended, but what is important is that a big part of those preferred stocks trade in the $2-$5 range( they are all cumulative). The easiest way to see those is here

What safety clauses are really important for investors.

  • failure to redeem penalties
  • maturity date
  • limit of the suspension periods
  • conversion clauses( both for face value and for dividends)
  • put clause
  • All additions in the comments section are welcome

Conclusion. The cumulative clause is the last thing you should consider when buying a preferred stock as an income vehicle. All my novice traders (including myself) at some point realize that there are preferred stocks that are cumulative and the discussion begins. Every newcomer finds those preferred stocks extremely safe. I now find it strange how a single word can mean so much when in fact it means nothing for the income investor.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.