Are Storm Clouds Gathering For Blue Chip Dividend Stocks?

by: Counterpoint

OK, I admit it, I am an interloper when it comes to investing in blue chip dividend stocks. It is only over the past year or so that I've added some targeted exposure to this sub-sector to overweight it in my portfolio. However, I am already starting to have some second thoughts as I see storm clouds reappearing on the horizon in the form of the likely changes in tax policy towards dividends.

Prior to EGTRRA (the so-called "Bush Tax Cuts"), dividends were taxed as ordinary income while capital gains enjoyed a comparatively lower rate, however EGTRRA coupled the tax rates for these items and reduced the top rate to 15%.

EGTRRA was to expire on 12/31/10 but it was extended to 12/31/12 during the contentious negotiations between Congress and the President at the end of last year. Now with Washington seemingly ever more dysfunctional, there is an increasing chance EGTRRA could fully expire at the end of 2012. If it does, dividends will again be treated as ordinary income which, in conjunction with the expiration of the reduced bracket rates, will mean an increase from 15% to 39.6% in the tax rate for those in the highest bracket. In addition, starting in 2013, the 3.8% PPACA (so-called "Obamacare") taxes kick in for those with incomes above $200,000 for individuals and $250,000 for married couples. This means investors in the highest marginal bracket would be left with $0.566 of every dividend dollar after federal taxes as opposed to the current $0.85...a 33% reduction!

The effects could be farther reaching than they appear at first blush. The more obvious effect would be a stock re-pricing based on the lower after tax cash flow. If 50% of the value of a stock is based on the dividend and the after-tax dividend is reduced by 33%, the value of the stock to a shareholder in the highest tax bracket is, in theory, reduced by 16.5%. Of course not every shareholder is in the highest tax bracket and stocks do not trade in this strictly mathematical way, but it seems obvious to me this would have some negative effect on the relative value of dividend stocks just as any dividend cut would.

Those in lower tax brackets who are more focused on income than stock price might think..."no big deal...the effect on me is much less"...probably true, but consider a more subtle effect from the corporate perspective. Dividend increases become relatively less attractive to alternatives such as stock buy-backs, acquisitions or capital investments as a way for corporations to boost share prices. This could lead to a reduction in future dividend increases.

Of course we can all hope that the Deficit Super Committee can arrive at a consensus for not only spending reductions, but for a rational long term tax policy as well. But the odds certainly seem stacked against this. We can also hope the 2012 elections bring some clarity and function back to Washington (regardless of your political persuasion) but right now, that seems unlikely too.

So what is one to do? Regardless of tax treatment, I believe it is still prudent to invest in blue chip stocks in these uncertain economic times. However, if I were investing in them as a fixed income alternative, depending on my tax bracket, I might prepare to shift a portion of my investment to high quality municipal bonds or high quality corporate bonds and/or blue chip equity REITs as the change in tax treatment outlined above would level the after-tax playing field among dividend stocks and these latter two assets classes. If I were investing in these stocks to provide income in retirement, I would probably sit tight, however, I would keep an eye on Washington and shift some of my TV time from CNBC to MSNBC or FOX (depending on your political leanings).

For someone (like me) who views blue chip stocks as a portfolio allocation decision, perhaps a personal version of "Operation Twist" should be considered. While most of the largest and strongest companies pay dividends, there are many with a dividend of less than 2%...even some that pay no dividend. In fact, according to data provided by the web site "indexArb" nearly 50% of the S&P 500 stocks currently have a dividend yield of 2% or less including 110 companies that pay no dividend at all. You can find that list here.

Now, not all of those companies are blue chips, but some are. Perhaps it is a good time to consider hedging your bets by swapping at least some of your higher dividend blue chips for lower dividend ones. I would enjoy seeing which stocks the many stock picking experts in Seeking Alpha Land think are roughly equivalent trades based on stock metrics other than dividends.

In any event, you may want to finish your drink...I think the Dividend Airlines pilot is about to put the seatbelt sign on...

Disclosure: I am long SDY and some equity REITs