The darlings of cautious investors are sitting on the edge of the "fiscal cliff" and feeling twinges of tax anxiety.
Much to the surprise of some investors, dividend-paying stocks — sleepy investments like utilities — along with real estate investment trusts (REITs), and master limited partnerships (MLPs), all have dropped in value since the presidential election. Nervous investors fear that all three could face higher taxes next year, and some have been selling high-yielding investments rather than wait for them to decline in value amid tax concerns later.
Unless Congress stops automatic tax increases by Dec. 31, dividend and capital gains taxes will shoot up Jan. 1 for middle-income as well as high-income taxpayers. And higher taxes would mean investors will retain less income than they imagined from their dividends. For some, that will make the investments less appealing and could lead to more selling.
For the highest income-tax payers, the tax rate on dividends will climb from the current 15 percent to 43.4 percent as dividends get taxed like ordinary income. With dividend taxes that high, a stock now yielding 3.6 percent would end up yielding just 2.4 percent after paying taxes. So the stock would have to fall 34 percent to get to a price adjusted to the lower after-tax income, said Gluskin Sheff economist David Rosenberg.
While REITs and MLPs provide income in a different form than dividends, and are not currently slated for a tax increase, the investments have been tainted anyway by tax concerns. As Congress searches for potential new tax revenue, some investors worry that REITs and MLPs might be tapped too.
Since the Nov. 6 presidential election, the SPDR Dow Jones REIT exchange traded fund, an index of real estate investment, has declined 1.9 percent. The SPDR Utilities exchange traded fund — filled with some of the highest-yielding dividend stocks — has lost 3 percent. And the JPMorgan Alerian MLP index, which includes infrastructure like oil and gas pipelines, has lost 4 percent. That's more than the stock market in general, which also has been declining, based on the fear that taxes on income and investments will shoot up Jan. 1 and send the U.S. into a recession. The Standard & Poor's 500 has declined 2 percent.
Analysts say that after going through initial selling, dividend stocks should still be attractive to investors because many retirees won't be in the upper income bracket, will want income for retirement expenses and will prefer the stability that solid dividend-paying stocks tend to offer over more volatile stocks. Although wealthy people would face the 43.4 percent tax rate, middle-income earners in the 28 percent income-tax bracket would only face dividend taxes at the 28 percent rate. And people who hold dividend-paying stocks in IRAs or 401(k) plans face no tax on those because the accounts are insulated from taxes.
REITs, MLPs and high-yielding stocks like utilities have been popular with retirees and others who feared the stock market after 2008 but wanted more income than bonds and CDs have provided in a near-zero interest rate environment.
Although MLPs and REITs are not set for a tax increase, BlackRock Global Allocation fund manager Dennis Stattman says he would be cautious about buying MLPs and REITs now because both became expensive amid their popularity the last couple of years. When an investment is expensive, it can fall sharply at a time of uncertainty.
Both REITs and MLPs "attracted a lot of money from people desperate for yield," Stattman said. While some actual real estate is inexpensive, the REIT funds are a different matter because investors flooded them with money.
"REITS are really expensive," said Josh Peters, editor of Morningstar DividendInvestor. They are yielding only about 3 to 4 percent, which looks attractive compared with U.S. Treasurys now yielding only 1.6 percent. But Treasurys won't always be that low, and when interest rates and inflation start climbing, REITs — which normally yield 5 to 7 percent — "will look like a poor investment," said Peters.
Utilities are also expensive now because they've been popular with risk-averse investors seeking high yields, Peters said.
"Although utilities have lagged of late due to fear of higher tax rates on dividends, the valuations are stretched, and if the market does rally, the group will get left behind," added Steven DeSanctis, Bank of America Merrill Lynch strategist.
Rather than selecting companies based simply on their high yields, Peters said, it is more reliable to pick companies such as McDonald's, with a history of growing earnings in addition to rising dividends. This is different than utilities, which tend to grow modestly. McDonald's, which has declined 2.3 percent in the dividend-stock sell-off since the election, has a 3.6 percent dividend yield.
"Dividend-growth stocks have been one of the only strategies that have consistently outperformed the market over the last few years and are currently trading at the biggest discount to high dividend yield stocks in at least two decades," said Merrill Lynch strategist Savita Subramanian.