November 12, 2012 2:22 pm

US investors fret over dividend tax

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The taxman cometh for US equity investors who depend on high-paying dividend stocks.

From retiring baby boomers to risk averse investors, equity dividends occupy a special place for many people who like the stability of companies that regularly pay out income and generate long-term wealth for their portfolios.

High yielding stocks underperform

High yielding stocks underperform

Across western economies, investors have flocked to dividend-paying stocks in recent years with asset managers touting them as the “new fixed income” alternative to bonds that pay meagre yields.

In the US the appeal of owning dividend paying stocks has been enhanced by their tax treatment, with payouts taxed at 15 per cent since 2003 instead of at personal income levels. In contrast, income from bond funds is taxed at higher personal rates.

That 2003 deal is about to expire, part of the fiscal cliff of mandatory tax increases and spending cuts that, left untouched, are expected to push the economy into a recession next year. Investors fret that even a political deal to fix the fiscal cliff will not save the dividend tax break.

Evidence of concern has been visible over the past month as investors have focused on the elections and the fiscal cliff. While the broad S&P 500 index has dropped 4.2 per cent, telecoms and utilities, the two big sectors that pay the highest dividends, have fallen 7.3 per cent and 6 per cent respectively.

S&P utility companies pay an average dividend of 4.2 per cent while the telecoms sector sports an average yield of 4.8 per cent. That is much higher than the 2.2 per cent average for the S&P 500.

“At the margin there will be some investors who will sell dividend paying stocks for tactical reasons and figure they can buy them back at cheaper levels,” says James Sarni, managing principal at Payden & Rygel.

But he says many investors, particularly retirees, are likely to stick with high dividend paying stocks, given their need for income and the dearth of alternatives.

“I question whether people who need income to maintain a certain lifestyle will sell a stock and forgo the dividend. We are finding that a much greater percentage of investors want to be in an inherently stable part of the equity market and exploit the income.”

Europe also feels the pinch

Dividend paying stocks have been clear underperformers in Europe this year as action by central banks has prompted a rise in risk appetite and big defensive sectors have been hit by tax worries, writes Michael Stothard .

The total return on the MSCI European Index of about 500 companies has been 13.8 per cent, with stocks lifted by the European Central Bank’s €1tn longer-term refinancing operation in February and promise
of bond buying in September.

But in a bullish market, high dividend paying stocks, which tend to be larger companies in more defensive sectors, have performed less well. The total return on the MSCI Europe High Dividend Yield Index has been just 4.4 per cent.

The index has been held down partly by the weakness of telecoms and utility stocks based in the European peripheries.

These stable companies usually have a large amount of debt, and so are vulnerable to ratings downgrades should the financial situation of their sovereign worsen. Investors also worry that taxes could be increased to help fill a fiscal hole.

The two worst-performing sub-indices on the benchmark Eurofirst 300 index this year have been the Fixed Line Telecommunication Index, down 19 per cent, and the Electric Index, down 13 per cent.

“The long-term track record of European dividend paying utilities is strong, but many are now seen as more risky to some extent because of the European sovereign crisis and what could potentially happen to their borrowing costs and tax burden,” said Manu Vandenbulck, senior portfolio manager at ING Investment Management.

European companies traditionally pay higher dividends than in the US. The average dividend yield in Europe is 4.3 per cent, compared with less than 2.3 per cent in the US, according to the MSCI Europe and MSCI US indices.

Michael Kastner, partner at Halyard Asset Management, says the real shock for ordinary investors will not register until they see their tax bills.

“Initially, professional investors will sell dividend payers and after some calm people will see how much tax they need to pay and we will then see another round of selling.”

So far in 2012, the S&P Dividend Aristocrats index of companies that have consistently increased their payouts down the years is up 10.3 per cent, beating the 9.7 per cent gain for the S&P 500.

But since the start of August, the top fifth of dividend-paying companies in the S&P have underperformed the broad market by 3.2 per cent according to Vadim Zlotnikov, chief market strategist at AllianceBernstein. “You can’t argue that the threat of higher taxes is not important for investors,” says Mr Zlotnikov.

He also contends that dividend stocks fare less well when riskier stocks do better and central banks are committed to reflating economies. These factors have influenced the stock market this year and help explain the dramatic underperformance of utilities, with the sector down 4.1 per cent since January.

“Investors see dividend stocks as a way to dip their toes into the market and own something that has stability and is more bond-like,” says Mr Zlotnikov.

However, not everyone on Wall Street sees doom and gloom for dividend payouts.

Analysts at KBW say tax rates on capital gains and dividends may rise slightly as part of a fiscal cliff deal, possibly to 20 per cent, with the 3.8 per cent surcharge under Obamacare on top.

“We think it is unlikely that the top tax rate on dividends will rise to ordinary income [tax rates],” KBW says.

David Bianco, head of US equity strategy at Deutsche Bank, says the importance of dividends for investors cannot be understated in the present climate of low interest rates.

“Dividends are the tangible connection between the price earnings multiple and low interest rates. If companies can keep raising dividends we can get more P/E expansion. Much higher taxes on dividends are a worry.”

James Paulsen, chief investment strategist at Wells Capital, says the real threat is the end of low interest rates that make the sector so appealing irrespective of tax changes.

“Until the bond bubble ends, the dividend trade will continue,” he says.

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