Understanding Non-Cumulative Preference Shares

Preference shares are a popular form of equity investment, offering fixed dividends and preferential treatment over common shareholders in terms of payments. Among the different types of preference shares, non-cumulative preference shares stand out due to their unique characteristics. These shares are designed to provide fixed income to investors without the accumulation of missed dividends.

This article explores the features of non-cumulative preference shares, compares them with cumulative preference shares, and discusses the benefits and risks involved. By understanding these shares in-depth, investors can make informed decisions on whether they fit within their portfolios, especially those looking for predictable income with lower risk.

Non-cumulative preference shares pay a fixed dividend, but any unpaid dividends are not carried over. If a company fails to make a dividend payment in a particular year, shareholders cannot claim those missed payments in the future.

Features of Non-Cumulative Preference Shares

Non-cumulative preference shares have several distinct features:

• Fixed Dividend Payment: Non-cumulative preference shares deliver consistent, fixed dividends, ensuring a reliable return for investors.
  

• No Dividend Accumulation: Non-cumulative preference shares do not carry forward unpaid dividends like cumulative shares do. If a company skips a dividend in a particular year, shareholders lose that payment entirely.
  

• Priority Over Ordinary Shares: Non-cumulative preference shareholders are prioritised above common shareholders for receiving dividends and liquidation payments.
  

• Non-Participatory: Non-cumulative preference shares do not entitle shareholders to any further profits or participation in additional earnings beyond the fixed dividend.
  

Non-Participation in Company’s Profit

Non-cumulative preference shares are non-participating, which means that holders are entitled only to the fixed dividend rate. They do not benefit from any surplus profit that the company may distribute to its ordinary shareholders or through additional dividends. This characteristic makes them less volatile compared to common shares but limits potential for growth through additional earnings.

Priority in Dividend Payments

One of the key benefits of non-cumulative preference shares is the priority given to preference shareholders over ordinary shareholders when dividend payments are made. If a company is profitable and declares dividends, preference shareholders receive their fixed dividends before any distribution is made to common shareholders. This makes non-cumulative preference shares a more secure investment for those seeking predictable income, particularly in stable companies with consistent performance.

The main difference between non-cumulative and cumulative preference shares lies in the treatment of missed dividends. Let’s take a deeper look at these two types of preference shares.

Cumulative vs Non-Cumulative: Dividend Accumulation

• Cumulative Preference Shares: If a company fails to pay dividends in any given year, the dividends are accumulated and carried forward. Shareholders are entitled to receive the missed dividends in future periods before any dividend is paid to common shareholders.
  

• Non-Cumulative Preference Shares: Non-cumulative preference shares do not allow for the recovery of unpaid dividends in subsequent years unlike cumulative preference shares. If the company skips a dividend, it is lost to the shareholder.

Risk and Reward

While both cumulative and non-cumulative preference shares provide fixed income, non-cumulative preference shares tend to have more predictable income streams. However, they also carry higher risk, as there is no recourse for missed dividend payments. Cumulative preference shares, on the other hand, offer more protection since unpaid dividends accumulate, providing a more secure income stream over time.

Non-cumulative preference shares offer several advantages to investors looking for a steady stream of income and lower risk.

Predictable Income with Lower Risk

One of the primary benefits of non-cumulative preference shares is their predictable income. Investors receive fixed dividends, providing them with a consistent source of income. Additionally, non-cumulative preference shares are less volatile than common stocks, which can fluctuate widely based on market conditions.

Unlike common shares, where dividends are not guaranteed, preference shareholders, including non-cumulative, have a higher priority when it comes to receiving dividend payments. This prioritisation reduces the risk compared to investing in common stocks, especially in companies with stable earnings.

Suitable for Conservative Investors

Non-cumulative preference shares are an ideal choice for conservative investors who prioritise stability and low-risk income. These investors are typically risk-averse and prefer fixed-income securities over high-risk, high-reward investments. Non-cumulative preference shares provide a reliable income stream without the uncertainty that comes with common stock dividends.

Priority in Company’s Liquidation

In case of liquidation, non-cumulative preference shareholders are ahead of common shareholders in line for any liquidation payouts. This priority gives non-cumulative preference shareholders added security in case of financial distress, although their claims are subordinate to debt holders.

While non-cumulative preference shares provide predictable income and lower risk compared to common stocks, there are still some risks that investors should be aware of.

Risk of Non-Payment of Dividends

One potential risk is the non-payment of dividends. If the company does not fulfill its dividend obligations, non-cumulative preference shareholders will not receive those missed payments, potentially resulting in lost income during challenging financial times.

Fixed Dividend Risk

Although non-cumulative preference shares offer a predictable dividend, this fixed rate may prevent investors from capitalising on higher earnings during periods of strong company performance.

Restricted Potential for Capital Appreciation

Non-cumulative preference shares typically lack the growth potential of common stocks. Instead, their value remains relatively stable, and investors primarily earn returns through the consistent dividend payouts.

While non-cumulative preference shares focus on fixed dividends without accumulation, non-convertible preference shares have different features.

Key Differences

• Non-Cumulative: Provides fixed dividends without accumulation of missed payments.
  

• Non-Convertible: These shares cannot be converted into common stock, offering stability in income but no opportunity for capital gains through equity conversion.
  

Risk and Return Comparisons

Both non-cumulative and non-convertible preference shares are considered stable investments, but non-cumulative preference shares are more suitable for investors seeking regular income without the potential for future growth through stock conversion.

Investing in non-cumulative preference shares is relatively straightforward, but there are several ways investors can go about it.

Investing Through the Stock Exchange

Investors can acquire non-cumulative preference shares through public stock exchanges, such as the NSE or BSE, where they are available for trading. Investors can buy shares just like common stocks using their demat accounts.

Buying Through Mutual Funds

Some mutual funds provide exposure to non-cumulative preference shares as part of their diversified portfolio. Investing in mutual funds can provide investors with indirect exposure to non-cumulative preference shares, allowing for greater diversification.

Understanding Market Price and Dividend Yields

Before investing, it's essential to assess the market price of non-cumulative preference shares and calculate the expected dividend yield. The dividend yield is determined by dividing the annual dividend by the market price. This will give investors an idea of the returns they can expect from the investment.

Non-cumulative preference shares are suitable for specific types of investors. Here’s a look at the ideal investors for these shares:

Conservative Income-Focused Investors

Non-cumulative preference shares are perfect for conservative investors who want a fixed, reliable income without the risk associated with common stocks. These investors typically seek low-risk options that offer regular dividends.

Risk-Averse Investors

Investors who prefer to avoid volatility in their portfolios and are focused on securing consistent income will find non-cumulative preference shares appealing. They provide a safer alternative compared to more volatile assets like common stocks.

For investors looking for steady income with moderate risk, non-cumulative preference shares can be an appealing investment choice. While they offer predictable income streams and priority in dividend payments, they come with the risk of non-payment of dividends and limited capital appreciation. Understanding the features, benefits, and risks of non-cumulative preference shares will help investors determine whether they fit within their investment strategies.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.