Onefund is paying a tempting 11%yield . Another offers 8%.
Which one should you reach for?
To answer that, you need to ask the right question.
The question is not "How high is the yield?" Instead, it's
"How secure is thedividend ?"
Dividend safety is far more important to total returns than
yield size. My colleague, Elliott Gue, touched on this a few
Consider how chasing two of the S&P 500's highest
yielders, which carried dangerously unsecure dividends not too
long ago, would have impacted your returns.
Frontier Communications (
carried a yield over 18% before it chopped its quarterly dividend
by 60% in February 2012 (from 25 cents a share to 10 cents). Its
share price plummeted more than 26% over the three months
following the reduction announcement.
Pitney Bowes (
boasted a 10% yield until it cut its quarterly dividend by half
in April (from 38 cents a share to 19 cents). Its share price
fell 15% in
Put simply, dividend cuts that come from unsecure dividends
can cause some uncomfortable -- and often unnecessary -- investor
The good news is that it is fairly easy to protect yourself
from these losses and assess how secure dividend payouts are --
especially for income-focusedfunds . Here are the three warning
signs to watch:
Return of capital
Over-distributednet investment income
Return of capital:
When a fund makes regular payments consisting of "return of
capital," it can be a signal of a dangerous dividend. Often,
these payments are simply returns of investor'scapital or
Funds supplement their distributions with returns of capital
wheninvestment income orgains aren't enough to maintain the
dividend. In effect, the fund dips into its capital pool to
maintain the dividend.
Over-distributed net investment income:
Closed-end funds are required to distribute at least 90% of
theirtaxable income eachyear to avoid paying corporatetaxes on
They also must pass along at least 98% of their income and net
capital gains each year to avoid paying a 4%excise tax on what's
However, some managers elect not to distribute all income
earned during the year and instead pay the 4% excise tax on this
income. What's lost to taxes is gained inasset value, and the
undistributed net investment income (UNII) can be used to
supplement future distributions as needed.
So UNII secures the dividend and bodes well for dividend
In contrast, over-distributed net investment income -- when a
fund distributes more than it made in a year -- may be a sign of
dividend danger. The statement of assets and liabilities tells
you whether the fund has undistributed or over-distributed
Closed-end fund distributions typically can come from three
sources: return of capital, capital gains and investment income.
Of these, investment income from dividends and interest on
portfolio holdings is generally the most predictable as payments
are issued at regular intervals.
The payout ratio provides a handy measure of how much of the
fund's distribution comes from investment income, net of
expenses. The ratio provides a quick gauge of how secure the
yield is by the fund's current portfolio holdings. So if a fund
earns a dollar a share in net investment income and pays out 90
cents, then you can quickly see the fund can cover its payments
without dipping into its capital.
Action to Take -->
One thing to keep in mind: I'm not saying you shouldn't look
forinvestments with higher yields. But when it comes to making a
winning income investment, steady and secure dividends should be
your top goal. If you keep these three items on your checklist
when looking for a solid income investment, you should be on the
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