Dividend investors — first cousins to income-seeking bond buyers — can take a lesson from Puerto Rico’s roiling of the fixed-income market.
Friday is the last day for the Puerto Rico Public Finance Corporation (PFC), a subsidiary of the commonwealth’s Government Development Bank, to pay $58 million to bondholders before it, and therefore Puerto Rico, is in default. Such an event would be the first time that a state-like entity has defaulted on its bonds since Arkansas in the Depression year of 1933.
Since Puerto Rico is not a state, it doesn’t fall under the Chapter 9 provisions of the U.S. Bankruptcy Code that deal with municipal bankruptcies. Legally, therefore, Puerto Rico is in unchartered waters, which is not good news for the territory’s bond owners, including many municipal bond funds. As we noted in an earlier column, Puerto Rico’s bonds are exempt from federal, state and municipal income taxes, making them a perfect addition to any state-specific municipal bond fund — as long as they paid interest on their bonds.
Moral Obligation to Pay
And that’s where the rub of particular interest to dividend investors lies. Puerto Rico’s bonds are what’s known as “moral obligation” bonds. Devised by John Mitchell (yes, the one who became President Nixon’s Attorney General) for New York Governor Nelson Rockefeller, issuers of moral obligation bonds are not legally required to pay principal and interest to bondholders. But in order to satisfy investors, they establish a reserve fund that is intended to meet any debt service costs the issuer is unable to make.
We all know how New York’s moral obligation experience worked out: John Mitchell went to prison for his role in Watergate, and New York City teetered on bankruptcy in 1975, suffering for years as it worked its way out of a debt hole.
Puerto Rican bondholders, therefore, should have little faith in the issuer’s moral obligation to pay its debts. This seems to be a case of the issuer having not much in the way of morals and no sense of obligation to those who lent it money.
Implication for Dividend Investors
In the equity world, of course, there is no legal obligation to pay dividends in the first place, nor is there an obligation to continue paying dividends or to increase the dividend. Investors know this, which is one of the reasons why equity investing carries a risk premium.
But while they have no legal responsibility to pay shareholders a dividend, many corporations feel a moral obligation to share profits with owners on a regular basis. And as we know, many corporations — such as Johnson & Johnson (JNJ ), Procter & Gamble (PG ) and numerous utilities — take pride in their dividend-paying tradition and enshrine dividends in their corporate culture. They believe they have a moral obligation to pay dividends and they take that responsibility very seriously.
For dividend investors, therefore, the assuredness that dividends will continue to flow rests on whether the issuing corporation feels it has a moral obligation to pay dividends and whether that sense is a core belief of the company or just a passing fancy like so many management fads.
What to Do?
Two ways to help determine whether the obligation is real or a façade stem from checking a company’s dividend-paying record. First, check to see for how long it has paid dividends, whether it increases dividends regularly, and whether it has ever stopped paying dividends. Second, see whether top management traditionally comes from within or from outside. If a company has a strong dividend culture and its top people grew up within that culture, odds are dividends will continue to be important to them.
If you’re going to depend on moral obligation, make sure the people making the promise are moral and really do have a sense of obligation.
Get Email Updates
Join over 100,000 investors who get the latest news from Dividend.com
Dividend payers have proven time and time again, that in periods of malaise,...
Check our latest update on the Best Dividend Stocks List, wherein an industrial...