Ben Graham on Noncumulative Preferred Stocks

The most attractive feature of preferred stock as a financing tool is that a company can defer the payment of dividends, whereas traditional debt requires the timely payments of principal and interest, and missing a payment is a default.

When a company suspends the payment of preferred stock dividends it is generally prohibited from paying common stock dividends until the preferred dividend has been reinstated. Depending on the terms of the preferred stock, the preferred stock dividends may or may not accrue in the interim.

If a preferred stock is "cumulative", any missed or suspended dividends accrue and must be paid back in full before dividends can resume on the common stock. A preferred stock lacking the cumulative feature is called "noncumulative," and any dividends passed are lost forever if not declared.

Preferred stocks as a class are less attractive than debt because the holders cannot compel payment of the coupons. However, this is tempered by the requirement (on cumulative issues) that the coupons be paid before any payment can be made to the common stockholders. Given that incentive alignment, the higher yields on preferreds than on debt can be said to compensate for the flexibility that companies have to defer dividends.

That is most certainly not the case with the noncumulative preferreds, something that Ben Graham wrote about nearly a century ago in Security Analysis:

"The drawback of not being able to compel the payment of dividends on preferred stocks generally is almost matched by the handicap in the case of noncumulative issues of not being able to receive in the future the dividends withheld in the past. This latter arrangement is so patently inequitable that new security buyers (who will stand for almost anything) object to noncumulative issues, and for many years new offerings of straight preferred stocks have almost invariably had the cumulative feature."( p.197)

Graham mentions a 1930 federal court holding that "while the noncumulative provision may work a great hardship on the holder, he has nevertheless agreed thereto when he accepted the issue."

So, if Ben Graham wrote in the 1930s that a particular type of security is so bad as to be unconscionable, it probably doesn't exist anymore right? Wrong. I've noticed that there are currently outstanding close to 200 different preferred stock issues, mostly issued by financial firms.

We're talking about highly leveraged financial firms, with ratios of total assets to market capitalization of between ten and seventy times! And people are willing to lend them money, on the basis that interest payments can be skipped and never repaid by the company, at single digit interest rates!  That's less than some conservatively financed E&P companies pay on their convertible securities!