(The opinions expressed here are those of the author, a
columnist for Reuters.)
By Lewis Braham
PITTSBURGH, June 24 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
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.
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
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
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
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)