One fund is paying a tempting 11% yield. Another offers 6%. 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 the dividend?"
Dividend safety is far more important to total returns than yield size.
Consider how chasing two of the S&P 500's highest yielders a few years ago would have ended in nothing short of disaster.
Telecom provider Frontier Communications (NYSE: FTR) carried a yield over 18% in 2011. And while it may have looked tempting at the time, the company 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 three months following the reduction announcement and would lose more than half its value from its 2011 peak. The dividend declined further, year after year, until it was finally eliminated in 2018. Today, the stock trades for a shade over $1.
Pitney Bowes (NYSE: PBI) boasted a 10% yield until it cut its quarterly dividend by half in April 2013 (from 38 cents a share to 19 cents). Its share price fell 15% in one day.
Today, the stock trades for less than $5.
Put simply, dividend cuts that come from unsecure dividends can cause some uncomfortable -- and often unnecessary -- investor losses.
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-focused funds. (You can find most of the information we're going to discuss on sites like Morningstar or at the fund's website.)
Here are the three warning signs to watch...
1. 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's capital or shareholders' equity.
Funds supplement their distributions with returns of capital when investment income or gains aren't enough to maintain the dividend. In effect, the fund dips into its capital pool to maintain the dividend.
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 distributed.
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 in asset 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 increases.
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 income.
3. Payout ratio: 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: we're not saying you shouldn't look for investments 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 right track.