While most investors aren’t yet focusing on this fall’s US presidential election, one bit of politics has caught their attention: President Obama’s 2013 budget proposal includes a significant hike in the dividend tax rate. Under the proposal, which essentially lets the Bush tax cuts expire for the wealthy, the dividend tax rate for individuals earning $200,000 or more a year would basically triple.
In recent weeks, many investors have asked me how likely the proposal is to pass and if it does pass, what it would mean for the dividend paying stocks they have increasingly embraced as a bond substitute in today’s low yield world. I address these questions below.
Q: How likely is the proposal to pass?
A: The president’s budget proposal is an opening salvo in what’s likely to be a contentious negotiation. Should the Republicans hold the House of Representatives and capture the Senate next fall, very little of the president’s current budget proposal is likely to become law even if Obama is reelected.
Q: If the proposal does pass, what does it mean for dividend investing strategies?
A: Assuming political stars align in such a way next fall that some version of President Obama’s current proposal looks likely to be enacted, I’d advocate paring back dividend paying stocks, particularly US Utilities.
If the preferential treatment of dividends expires, traditional dividend paying sectors will likely experience some compression in multiples. In other words, investors will be less willing to pay a premium for an earnings stream that is worth less after taxes.
Among traditional dividend paying sectors, the US utilities sector is likely to experience significant downward pressure and suffer the most in such a scenario. This is because in the aftermath of the 2003 Bush tax cuts, utility stocks have re-priced in a way that other dividend paying sectors haven’t.
Prior to the Bush tax cuts, utility stocks typically traded at a 25% to 35% discount to the broader market. Last year, however, the utilities sector was a top performer as investors overpaid for the sector’s safety and yield. By the end of December, the sector was trading at a 7% premium to the broader market.
More recently, despite the sector’s underperformance relative to global equities so far this year, utility stocks still appear quite expensive by most measures, and therefore vulnerable. As of the end of February, for instance, the sector was trading on par with the broader US equity market.
Q: So what should investors do now?
A: Since Obama’s proposal is unlikely to pass, I wouldn’t suggest going out now and selling dividend paying stocks. Instead, I currently advocate just underweighting US utility stocks. Investors looking for the relative safety of utility stocks should focus instead on a broad yield play such as the iShares High Dividend Equity Fund (NYSEARCA:HDV) and the iShares Dow Jones International Select Dividend Index Fund (NYSEARCA:IDV), and on global telecoms, which can be accessed through the iShares S&P Global Telecommunications Sector Index Fund (NYSEARCA:IXP).
Disclosure: The author is long IDV and IXP
Disclaimer: Past performance does not guarantee future results.
There is no guarantee that dividends will be paid. Narrowly focused investments typically exhibit higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations.