Whether dividends are safe is on most income investors’ minds, and for good reason. The final quarter of 2008 was the worst for dividends in a half-century, according to Standard & Poor’s. The first half of 2009 has seen even more cuts: 367 companies have reduced dividends since Jan. 1.

What’s behind many of these cuts? Debt.

There’s nothing wrong with debt. Every company borrows money at one time or another. But if cash gets tight and companies must pay off this debt, their dividends can be at risk. That’s because dividends are discretionary: Shareholders don’t have to be paid, but creditors do.

Knowing when a company’s debt comes due and whether it has enough cash to cover it is one key to dividend safety. To determine if it does, an investor needs to take a hard look at the balance sheet, cash-flow statement and the notes to the financial statements.

General Growth Properties, for example, said in a recent 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. As of September 30th, however, the mall owner’s cash-flow statement showed its business made just $408 million for the first nine months of 2008 and had only about $139 million in reserves. Without enough cash to pay its debt, it’s not surprising that General Growth suspended its dividend Oct. 3, 2008. The following April, it declared bankruptcy — the largest real estate failure in history.

Asset Coverage Is Key
Even if an entity does have enough cash on hand to pay its debt, it still might not be able to pay its dividend. Closed-end funds, for instance, are subject to a provision of securities law that requires each dollar of preferred stock issued be backed by $2 in assets, and each dollar of bank debt must be supported by $3 of assets.

The potential problem here is that the financial crisis has eroded asset values, and funds that are saddled with debt are at risk of violating those asset coverage ratios. In practice, that means a fund whose assets have fallen, could be prohibited from declaring or paying a dividend that would put it below the asset coverage ratio. Funds that find themselves in this situation must right the ship by selling assets to raise cash and reduce debt.

Late last year, for example, bond manager Pimco postponed previously declared dividend payments on about a dozen leveraged closed-end funds as asset values fell below the required coverage. During the next few months, the company reduced debt by redeeming its preferred shares. Then it was able to reinstate 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 said that dividends in 2009 were expected to be substantially less than those paid before the suspension.

How Can You Protect Yourself?
Investors can check a Closed-end fund‘s debt level at financial sites such as ETF Connect, or by going directly to the balance sheet in the fund’s latest annual or semiannual report.

You then can calculate the asset coverage ratio 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 — and the higher the better. In a bear market, where asset values can fall quickly, I would look for a higher margin of safety of an extra 25% beyond the required coverage.

Consider the Pimco High-Income Fund (NYSE: PHK). As of June 30, 2008, the fund had $1.07 billion in total assets, $321 million in liabilities and $336 million in preferred stock. Dividing the $749 million difference between the assets and liabilities ($1.07B -$336M) by the preferred stock provided 222% coverage ($749M/$336M). The fund also carries a hefty 16.2% yield.

Another choice is AllianceBernstein Global High Income (NYSE: AWF), which invests in corporate bonds and sovereign debt around the globe and yields 9.7%. Based on the fund’s most recent report, it has $763.4 million in total assets, $32.5 million in liabilities and $173 million in preferred stock. Dividing the $731 million in net assets by the $173 million of preferred stock, arrives at a coverage ratio of 421%.

If calculating ratios is not your cup of tea, don’t worry. I take all such measures into account for every fund I cover in High-Yield Investing.