Dividends Get Slashed

Business-development lenders, closed-end funds, some real estate investment trusts and other investment companies are scared to dip further into cash reserves to support generous payouts to their shareholders. That's good for their survival and doesn't mean there's anything amiss about these kinds of investments that a recovered economy can't cure. But it's tough on shareholders, who are finding fewer and fewer places to hide from the bear market, other than cash and Treasury bonds.

This became evident in November, when Allied Capital (symbol ALD) and American Capital Strategies (ACAS) said their 2009 distribution rates will fall drastically from 2008 levels. Since their confessionals, both stocks have plunged more than 60%, or about as much as a company's publicly traded bonds often lose on rumors of default. On December 8, Allied closed at $2.71 and American ended at $3.57. Both are down more than 90% in 2008.

Slashing distributions is not a default on obligations. And the fact is, no investment company can indefinitely pass out money it isn't earning. For years these and other publicly traded nonbank lenders and investors have paid hybrid dividends, part from operating income and part a return of capital. Their practice has been to name a year's cash distribution schedule in advance and make good regardless of results because earnings or profits from the sale of investments generally would replenish money paid to the stockholders.

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This is no longer feasible, American Capital's chief executive officer, Malon Wilkus, said when reporting third-quarter 2008 results -- a small operating profit but a large write-down on the balance sheet. He says ACAS will now assess each quarter's results and pay appropriate dividends. That's a polite way of telling shareholders to expect a pay cut and not to look for a raise anytime soon.

REITs, like BDCs, are also required to pay out nearly all of their taxable income as dividends, and they're finding it tough or impossible to promise 2009 dividends equal to or higher than this year's. Look for some famous REIT dividend-increase streaks to break, especially for companies that own office buildings and retail structures.

Yields look high because REIT share prices are down, but cash flow is weak, so dividends could fall 10% to 30% next year, says Jay Leupp, a fund manager and analyst for Grubb & Ellis Realty Investors. Leveraged closed-end real estate funds are even worse off, and some may have to liquidate.

Raiding capital to pay distributions sounds naughty. But it is neither illegal nor dishonest. A company must tell you what part of a distribution is regular interest or dividend income and what isn't, for tax reasons. Cash paid out of capital isn't taxed as you receive it. Instead it diminishes your basis in the shares, adding to your capital-gains liability or (more likely now) narrowing your loss if you sell.

A little of this is actually a treat if you can use tax-deferred cash flow now more than a tax break later. Trouble is, unless the enterprise clears enough profit to rebuild its capital reserves, it is cannibalizing itself. The net asset values per share of BDCs, lots of closed-end funds, and REITs are already melting from deflation in the value of their assets-land, buildings, loans, equity in creditor companies and other securities.

By one estimate, REITs are now trading for 75% of their net asset value, but those asset values are down by as much as half. So it's unclear that the shares are cheap. In any case, REITs cannot sell land and buildings at a gain now just to keep a quarterly payout number from lowering.

These cuts in payouts are especially painful for holders of Allied and American shares. Both stocks are overwhelmingly owned by individuals attracted by the income.

Until 2007, both BDCs did as well as the best REITs and did better than other high-yield investments, such as junk bonds and emerging-markets bond funds. Allied defended itself against a government investigation and short sellers' attacks and protected its share price until October of this year. But once bailout mania hit early this fall, the market slashed the value of anything that seems banklike but cannot get money from the Federal Reserve.

In a rough environment, "we need to pay down debt -- we have to weather this credit cycle," Allied chief executive William Walton said when he detailed the lower payout policy. There's one last 65-cent quarterly dividend this year. Then Allied's distributions will track net investment income, which it forecasts to be 20 to 25 cents a quarter in 2009.

At American Capital, Wilkus says, "we think we have to focus on conservation and retention of capital" because the company had to write down its assets by $731 million. Most of this was in failed investments, such as "managed finance" and mortgage securities that the company held for its own accounts. Few of American Capital's direct loans to businesses are in arrears, at least so far. Still, this will lower the company's distribution for 2009 from what was a reliable $1 a quarter to no more than the 72 cents it earned from operations in the last quarter and probably less.

These dividend cuts should still leave some value on the BDCs' books. If Allied can earn and pay 25 cents a quarter, or $1 a share for 2009 and the stock traded at its average historical yield of 12%, the shares could bounce to $8. American Capital, whose dividend policy is murkier, should also bring more than the $3 and change it's trading at now.

Still, I would wait for the recession to end before buying shares of either enterprise. If you've held the shares on the way down, it's too late to sell, but don't average down.

So, is there anything that should still be safe for high income that's not a bond? There is. It's pipeline stocks, and I'll go into detail on them in my next column.