Question: Why are so many companies suspending or cutting their dividends lately, and what can I do to protect myself from this trend? My problem is not just which securities to avoid, but what about the ones I already own?
Answer: This question is on just about every income investor's mind, and for good reason. The final quarter of 2008 was the worst for dividends in over half a century, according to Standard & Poor's. It was the first quarter in which dividend cuts and suspensions outnumbered increases and initiations since Standard & Poor's started keeping records in 1956.
For some 7,000 publicly owned companies that report dividend information to S&P, the last three months of 2008 saw five times as many dividend cuts and -40% fewer dividend increases than in the last quarter of 2007.
Behind many of these dividend cuts, there's a four-letter word: Debt. There's nothing wrong with using debt to grow the business, but in today's extremely tight credit markets, debt is associated with another four-letter word: Risk. Dividends are discretionary, so when it comes time for a cash-strapped company to pay off its debt, dividends become vulnerable.
Knowing when a company's debt comes due and if it has enough cash flow and cash reserves to cover this amount is one key to dividend safety. Essentially, this precautionary measure involves taking a good, hard look at the balance sheet, the cash flow statement and the notes to the financial statements as well.
For example, shopping-mall owner General Growth Properties (NYSE: GGP) stated in Note 1 to its latest bear market, where asset values can quickly evaporate, we would look for a higher margin of safety of an extra 25% or more on the required coverage.
Consider the PIMCO High Income Fund (NYSE: PHK). As of September 30th, the fund had $2.39 billion in total assets, $496 million in liabilities and $900 million in preferred stock. Dividing the $1.89 billion difference between the assets and liabilities ($2.39B -$496M) by the preferred stock provided 210% coverage ($1.89B/$900M).
Over the next month, PHK's assets declined along with the broader market and didn't provide adequate coverage. By November, management was forced to suspend the previously declared distribution, as well as the then-current month's distribution. By mid-December, however, it had redeemed enough preferred stock to raise the ratio and reinstate the distribution.
If calculating ratios is not your cup of tea, don't worry. We take all such measures into account for every fund we cover in Estate (AMEX: SRQ)
We would tread with caution into any company that has recently suspended dividends like those in the above list. The first five on the list are leveraged closed-end funds with credit issues. However, that doesn't mean you should avoid all leveraged closed-end funds. Asset coverage is just one measure of a fund's income potential at that time. In deciding whether to keep or add a leveraged closed-end fund with adequate asset coverage, you also want to consider other factors that may work in its favor. For example, if leverage is fairly low and the fund holds low-risk assets, the dividend should be secure.