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Tariq's Take: Like Dividend Stocks? Beware the Fiscal Cliff

24 August 2012 in Trading Ideas

Dividend-paying stocks have been on a tear over the last 12 months, rising 26.7%, as investors chase yields in the current zero-interest rate environment.  These stocks offer the compelling combination of potential income along with their status as defensive plays should the economy fall back into recession.

It pays to be cautious whenever a run-up like this occurs, and that is especially true for dividend stocks, which have tended to be slower-growth, more mature companies. 

However, the more immediate threat confronting these names is what has not-so-affectionately been termed as the “fiscal cliff.”

Scheduled to take effect next year, this package of laws would rescind the Bush tax cuts and effectively increase tax rates on dividends to 39.6% from 15%.  To put this in context, a tax increase of nearly 25 percentage points could cut a 2% dividend yield down to 1.51%, making it much less attractive.

Meanwhile, income from other asset classes could remain largely unaffected.

What is particularly alarming about the fiscal cliff is that it doesn’t require an act of Congress to put it into force. Rather, it will need an act of Congress – and President Obama’s signature — to stop it. Given the current political landscape and the fact that we are in an election year, the chances of a bipartisan agreement by year’s end seem remote. 

History tells us that periods of uncertainty caused by government inaction can cause large shifts in the market. For example, during the federal debt-ceiling debate last summer, the S&P 500 dropped 11% during those 10 trading days (July 25-Aug. 11) — and even supposedly defensive-minded dividend stocks dropped 9%. That provided some protection, but not a lot.

If something similar happens this year, dividend stocks could face the double barrel of uncertainty plus a potentially large tax increase, making them especially vulnerable.

So, what is an investor to do? One option would be to consider rotating into other income-generating assets that avoid the large tax increases promised by a post-fiscal cliff world.  For example, some municipal bond funds pay dividends that are exempt from federal income taxes and may therefore be largely unaffected. Their relative yield can become  more attractive vs. dividend stocks as the fiscal cliff approaches.  

In addition to the generated income, if munis become more attractive than dividend stocks, bond prices could rise, which could boost the potential for capital gains for those investors who elect to shift their investments this year. 

Of course, there are always risks with any asset class, and any bond investor should consider interest rate and default risks, among others.  While the fiscal cliff doesn’t really impact these issues directly, it can have a major effect on your after-tax yield relative to dividend stocks.

If you prefer equities, real estate investment trusts and master limited partnerships have traditionally offered strong dividend yields (often above 7% in the case of MLPs) without the huge risk of a change in dividend tax rates.  Both enjoy tax-advantaged status, which allows them to avoid corporate income taxes if they distribute 90% of their earnings to shareholders.  

The tradeoff is that shareholders have to pay income taxes on dividends at standard rates. However, that’s nothing new — since these dividends never benefitted from the dividend tax break, they could be largely unaffected by the fiscal cliff.

Like any event, the fiscal cliff poses a potential threat that can bring significant volatility and uncertainty to the marketplace. For a forward-thinking investor who can adapt to the changing landscape, however, it can also be an opportunity.

Tariq Hilaly is co-founder and chief investment officer of Motif Investing.