The three different types of preferred stock funds are fixed-rate cumulative, non-cumulative, and trust-preferred. Preferred stock has a fixed par amount, or repurchase value, but pays dividends to the investor over the life of the investment. The way dividends are paid out to investors distinguishes the different types of funds.
Corporations can issue bonds, preferred stock, and common stock to capitalize its operations. Bonds are debt instruments that are used to borrow money from investors at an agreed upon interest rate with principal to be repaid on a particular date. Common stock is an equity instrument that provides the corporation with investment capital from investors that take a percentage of ownership in the company in exchange for their funds. Preferred stock falls between these two instruments, with features of both. This type of stock is sold to an investor at fixed face value but with the promise that if the company issues dividends, the holders of preferred stock will be paid their dividends first.
Fixed-rate cumulative preferred stock funds guarantee the payment of dividends every year. If the company defers the payment of the dividend, the amount accumulates until the corporation pays the obligation. The only way the corporation can get out of paying accumulated dividends to holders of preferred stock in this sort of fund is if the corporation goes bankrupt. Fixed-rate cumulative is considered to be the safest type of preferred stock fund because the accumulation of dividends serves as an incentive for corporations to pay out every year.
Non-cumulative preferred stock funds are a much less attractive investment and have to offer a higher yield to compensate for the uncertainty of the dividend payment. Holders of stock in this sort of fund are not guaranteed a dividend payment every year. If the corporation decides not to pay a dividend, the amount does not accumulate. The only benefit to holding this type of preferred stock is that a holder will get paid a dividend before common stock holders, whenever a dividend is paid.
Trust-preferred stock funds are a tax code-created investment vehicle that has special tax benefits to the company setting up the trust. A third party company, such as an investment company, sets up a trust that purchases bonds. It then sells preferred stock in the trust. The dividends are paid out of the guaranteed interest payments that are paid on the bonds held by the trust. Since the interest payments on the bonds are guaranteed absent default, the preferred stock dividend payments are also assured.