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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 quarterly financial statement that it had $958 million of debt maturing in December 2008 and another $3.07 billion it would need to pay off in 2009. However, as of September 30th, the statement of cash flows showed the company churned out just $408 million in cash flow for the first nine months of 2008 and had only around $139 million in cash reserves. With not enough cash to pay off its debt, it's not surprising that on October 3rd the company said it was suspending its dividend indefinitely. Asset Coverage Is Key Now another problem is presenting itself. The market downturn has beaten down asset values, and funds that are saddled with debt are at risk of violating certain ratio requirements. One of these requirements is stated in Section 18 of the Investment Company Act of 1940. Under the legislation, closed-end funds must maintain an asset coverage ratio of at least 200% of senior securities, such as auction-rate preferred shares, and at least 300% of senior bank debt. In other words, for each $1 of preferred stock issued, a fund must have at least $2 in assets, and for each $1 of bank debt, a fund needs at least $3 of assets. For the income investor, this ratio means a fund is prohibited from declaring or paying a dividend that would put it below the asset coverage ratio. Funds that violate the asset coverage ratio must attempt to deleverage -- sell assets and raise cash to reduce debt. For example, late last year bond manager PIMCO postponed previously declared dividend payments on about a dozen leveraged closed-end funds, as asset values fell below the required coverage. Over the next few months, the company reduced debt by redeeming their preferred shares and reinstated the dividends. Most of these dividends were reinstated at the previous rate, but a suspension often can signal that a dividend cut is in order if and when the fund continues payments. RMR Funds, for example, suspended dividends on five of its closed-end funds in October. Two months later, the company announced that dividends in 2009 "are expected to be substantially less" than those paid before the suspension. What Can You Do to Protect Yourself? Once you've identified a new or existing closed-end fund, you can check its debt levels at financial sites such as Yahoo! Finance or ETFConnect.com, or by going directly to the balance sheet in the latest annual or semi-annual report. You can then calculate the asset coverage ratio simply by subtracting the fund's total liabilities (excluding senior debt or preferred stock) from total assets and dividing by the preferred stock or notes payable. The asset coverage should be at least 200% on preferred stock and 300% on senior debt -- the higher the better. In a 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 High-Yield Investing. We also alert you to investment ideas that may be best left alone, as in the blacklist below. All of these firms sport enticingly high yields, but have placed their distributions on hold.
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. Good investing! [http://www.streetauthority.com/includes/editor-profiles-hy.htm]Disclosure: Carla Pasternak not own shares of any of the companies mentioned.
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