COLUMN-When you should be wary of that high dividend

Mon Jun 23, 2014 3:45pm EDT

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Lewis Braham

PITTSBURGH, June 24 (Reuters) - If you are hungry for income, it is hard not to salivate over double-digit dividend yields that some closed-end funds offer, when most stocks only pay around 2 percent.

But put your tongue back in your mouth. Numbers like this do not come from earned dividends but are simply a so-called "return of capital."

Basically, this means that funds pay existing shareholders their own capital back to them. It is equivalent to handing someone a dollar and that person handing it right back to you and saying it is a dividend.

In a world where many retirees are starved for income, chasing dividends has increasingly become a hazard. With yields on most securities so low, it is easy to be tempted by such seemingly high payouts, even though there are ways of detecting whether a dividend is feasible. More than ever investors need to be vigilant.

Funds to look out for are mostly closed-end equity funds such as MFS Special Value Trust and DNP Select Income . Also look out for those with so-called "managed distribution" policies that promise elevated payouts in advance.

You can find which funds have such distribution policies at the Closed End Fund Center (cefa.com/ManagedDistributions/default.fs). You can also find out how much of an individual fund's distributions are actually from earnings (cefaconnect.com).

In the case of one such fund, the Cornerstone Total Return , 7 cents of its 8.7 cents distribution in May was a return of capital.

To make matters worse, the Cornerstone fund trades at about a 14 percent premium to its underlying portfolio value. Shares of closed end funds trade independently of their portfolio values, at premiums or discounts.

That means for every $1 of return of capital you receive from the fund you are paying $1.14. Cornerstone did not return requests for comment.

BOND DIFFERENCES

A red flag for bond funds, meanwhile, is negative undistributed net investment income (UNII), which indicates how much funds have in their coffers to pay future dividends.

"Based on our research, 41 percent of closed-end funds have a negative UNII balance," says Bryn Torkelson, chief investment officer and founder of Deschutes Portfolio Strategies, a firm that specializes in closed-end fund investing. "Those are candidates for dividend cuts."

In particular, many municipal bond funds may be due for cuts, as they have rallied hard this year and yields on newly issued bonds are skimpy as a result. If you go to management company websites, you can often find UNII data indicating which funds may be at risk. The more current the data, the more valuable it is.

At Nuveen.com, for example, the site lists the UNII data for all of its funds with roughly a few days lag (bit.ly/Uu58hF). This May, the Nuveen Quality Municipal Fund had a negative 2.6 cent-a-share UNII. Muni funds must earn their dividends via investments in bonds that pay the fund income - which the fund then pays to shareholders. But, in this case, the fund was only earning 5.4 cents of its payout via its bond portfolio and paying out more than it earned.

DIVIDEND PAYOUT RATIO

With individual stocks, figuring out the viability of a dividend requires looking at different metrics. A key one is the dividend payout ratio, which measures the past 12 months worth of dividends relative to earnings. The higher the ratio of dividends to earnings, the more likely a dividend is unsustainable.

The good news is that most stock payout ratios are currently low by historical standards. "Right now the S&P 500 is at a 36 percent payout ratio in terms of earnings," says Diane Jaffee, manager of the TCW Relative Value Dividend Appreciation Fund . "Historically, that number's been about 50 percent. So we think the average S&P stock has more room to grow its dividends."

That said, Jaffee notes that the highest yielding sectors - consumer staples, utilities and telecommunications - have much bigger payout ratios.

Instead of seeking the highest dividends, Jaffee prefers stocks with strong cash flows and low payout ratios. She points to tech company Cisco Systems, which has a 3.1 percent dividend yield. The company has a payout ratio of 33 percent and

has tripled its quarterly dividend in the last three years, to 19 cents a share. Jaffee thinks its current dividend has more room to grow, upward of 5 percent a year over the next three years.

In other words: if a company or fund's dividend yield seems too good to be true, it probably is. (Follow us @ReutersMoney or here. Editing by Beth Pinsker, Lauren Young and Steve Orlofsky)

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