Three Warning Signs of a Dangerous Dividend

One fund is paying a tempting 11% yield. Another offers 8%. 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. I touched on this idea a few weeks ago.

World Wrestling Entertainment (NYSE: WWE) chopped its dividend by two-thirds in late April. The shares fell 9% in a day.

Alpine Total Dynamic Dividend Fund (NYSE: AOD) cut its monthly payments in half from $0.12 a share to $0.055 back in June 2010. The shares fell more than 13%.

The good news is that it is fairly easy to assess how secure payouts are -- especially for income-focused funds. Here are the three warning signs to watch:

• Return of capital
• Undistributed net investment income (UNII)
• Payout ratio

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 an investors' own 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 keep up the dividend.

Undistributed net investment income (UNII) -- Closed-end funds are required to distribute at least 90% of their taxable income each year to avoid paying corporate taxes on what's distributed. 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 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.

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 secured the yield is by the fund's current portfolio holdings. So if a find earns $1.00 per share in net investment income and pays out $0.90, then you can quickly see the fund can cover its payments without dipping into its capital or depending on stock gains.