Rising Corporate Tax Rates? These 3 High-Yield Stocks Are Unaffected

Summary

• Congress is currently debating and negotiating a bill that would raise corporate tax rates from 21% to 26.5% (or 25% if certain moderate senators have their way).
• This would hurt most companies by incrementally raising their effective tax rates.
• However, there are classes of stocks that do not have to pay any corporate tax rates. Instead, shareholders pay taxes at their personal income tax rates on dividends.
• I highlight three of these pass-through stocks: a BDC, a REIT, and an MLP.
• Looking for a helping hand in the market? Members of High Yield Landlord get exclusive ideas and guidance to navigate any climate. Learn More »

Dzmitry Dzemidovich/iStock via Getty Images

The Looming Threat of Higher Corporate Tax Rates

Last month, the House of Representatives' Ways and Means Committee released its proposed "tax and spend" bill that Congressional Democrats hope to pass through the reconciliation process, which would require only a basic majority vote (50% or more) to pass.

Here are some of the major tax changes the $3.5 trillion reconciliation bill would make:

• The corporate tax rate would change from a flat 21% to a graduated rate from 18% to 26.5%. However, large corporations with over $10 million in profit would simply pay a flat 26.5%.
• The top marginal personal income tax rate would be lifted from 37% to 39.6%.
• The long-term capital gains tax would increase from 20% to 25%.
• A high-income surcharge of 3% of adjusted gross income would be added to individuals making over $5 million per year.

However, given Democrats' very thin majority in the House of Representatives (220 to 212) and 50-50 split in the Senate, the party cannot afford to lose a single vote in order to pass the reconciliation bill as-is.

As of now, it looks unlikely that the $3.5 trillion bill will pass in its current state because of two Democratic defections: Senator Joe Manchin of West Virginia and Senator Kyrsten Sinema of Arizona, both representing mostly Republican states.

Senator Manchin, in particular, has made certain demands about tax changes that must be met in order to win his vote:

• No higher than a 25% corporate tax rate,
• 28% capital gains tax rate, and
• 39.6% top marginal income tax rate

Notice that though Manchin wants a lower corporate tax rate than that of the reconciliation bill, it is still higher than the present 21%. What's more, Manchin is also comfortable with a higher capital gains tax rate than the reconciliation bill calls for.

More of a holdout against tax hikes is Senator Sinema. Reportedly, Sinema has made clear her opposition to any tax rate increases for both corporate and personal income. But Sinema is just one senator facing a lot of criticism and backlash for her stance against tax hikes.

Assuming Sinema bows to the will of her party and tax hikes pass through both wings of Congress to ultimately become signed into law, many stocks will take a hit. After all, higher tax rates mean lower after-tax profits.

However, regardless what happens in Washington D.C., there are certain kinds of stocks that will remain unaffected no matter what. I'm talking about public companies that are structured as pass-through entities, such as business development corporations ("BDCs"), real estate investment trusts ("REITs"), and master limited partnerships ("MLPs").

These kinds of companies pay no tax at the corporate level at all. But in exchange, they must pay out at least 90% of their net income to shareholders, and shareholders must pay taxes on those dividends at their regular income tax rate instead of the usual 15% or 20%.

Well, personal income tax rates are unlikely to go up for most people, even if the reconciliation bill passes in more or less its current form. Only very high-earners would be paying more via a higher top marginal rate.

In other words, if Democrats succeed at passing a reconciliation bill with tax hikes for corporations, the taxation of BDCs, REITs, and MLPs will be completely unchanged for most people, thus increasing their attractiveness in comparison to non-pass-through stocks.

Armed with that information, let's look at three of such unaffected stocks — all attractively valued and high-yielding — for investors to consider.

1. Capital Southwest (CSWC)

• Dividend Yield: 7.28%

CSWC is a BDC that has absolutely ripped higher in the last year — over 84% in twelve months' time. Since I penned an article on CSWC titled "A Wonderful High-Income Company At A Fair Price" in January 2020, the stock has delivered a total return of about 55%.

CSWC shares a lot in common with the perennially popular Main Street Capital (MAIN), a Houston-based BDC with a great track record and strong alignment of interests between management and shareholders. In fact, CSWC even co-manages a senior loan fund with MAIN called the "I-45 Fund," named after the highway that stretches between Houston and Dallas, where CSWC is headquartered.

It appears as though the market has picked up on CSWC's quality, now awarding the company with a higher premium to NAV (net asset value) than it has traditionally enjoyed. Before the pandemic, CSWC regularly traded between 1.1x and 1.2x NAV. Today, it trades at 1.56x NAV.

While investors may find it unappealing to buy shares of a BDC at such a premium to NAV, it is actually good for CSWC's business model, which is to issue a combination of equity and debt to invest in high-yielding loans (and some equity) to middle-market companies. Since the end of 2020, CSWC's portfolio investments have increased by 23%.

CSWC August Presentation

If interest rates were to rise from their current levels, it would benefit CSWC's portfolio, which consists overwhelmingly of floating rate loans.

CSWC August Presentation

Though falling interest rates brings down CSWC's loan asset yields, it also brings down the cost of its own debt. For instance, the BDC recently issued $100 million of bonds due 2026 at an effective yield of 3.5% to redeem 5.375%-yielding bonds due in 2024, thereby reducing quarterly interest expenses by $0.02 per share.

CSWC also recently raised its quarterly regular dividend by 6.8% to an annualized $1.88 per share. This is actually the third dividend raise this year, and CSWC also declared a $0.50 supplemental dividend to be paid along with its regular dividend in December.

Frankly, few stocks reward shareholders as richly as CSWC does.

2. Physicians Realty Trust (DOC)

• Dividend Yield: 5.17%

DOC is a healthcare REIT that primarily owns medical office buildings ("MOBs"). Its portfolio consists of 274 properties, 94% of which are MOBs (by NOI), that are 96% leased by gross leasable area.

DOC June Presentation

What sets DOC apart from its other MOB REIT peers is a focus on three things:

1. Off-campus (i.e. not attached or adjacent to hospitals) properties: 47% of the portfolio
2. Investment-grade credit tenants: 62% of the portfolio
3. Tenants affiliated with health systems: 89% of the portfolio

As technology improves and the healthcare system evolves, more and more care is being provided at outpatient facilities rather than hospitals. COVID-19 only accelerated this trend, as hospitals became (and continue to be) inundated with COVID patients at the expense of those with other needs, such as elective surgeries.

In the second quarter, DOC generated normalized funds available for distribution ("FAD") of $55 million, or $0.25 per share, an increase of 3.6% year-over-year. Compared to a quarterly dividend of $0.23 per share, that marks a 92% payout ratio. While that is a high payout ratio, it has come down quite a bit from the 100%+ ratio of 2014 through 2016. DOC is growing its FAD per share, albeit at a slow pace.

Investors in DOC should be aware that while the REIT is very defensive, growth will likely never exceed the low- to mid-single digits per year. One reason for this is that the spread between the cap rates (initial NOI yields) of DOC's acquisitions and the REIT's cost of capital is pretty thin.

Management has guided for $400 million to $600 million of investment volume for 2021. The REIT expects to pay between 5% and 6% cap rates for these acquisitions, roughly in line with acquisition cap rates in the mid-5% range in 2019 and 2020.

Compare mid-5% acquisition cap rates to DOC's cost of equity of about 4.85%, cost of debt around 3.69% (including the credit facility), and combined cost of capital of around 4.5%. That's about a one-point spread between cap rates and cost of capital.

Even so, with a BBB credit rating and a leverage ratio (net debt to EBITDA) of 5.02x, below management's target of 5.25x, DOC should be able to lower its cost of debt further in the years ahead.

3. Enterprise Products Partners (EPD)

• Dividend Yield: 8.26%

EPD is a master limited partnership (meaning that it issues a K-1 Form for tax purposes) that operates in the midstream oil and natural gas space. It is one of the largest, most successful, and most conservatively managed midstream energy companies in which you can invest through the public markets, as illustrated by its 22-year consecutive distribution growth streak.

By "midstream," I'm referring to the part of the energy business that goes between upstream (exploration & production) and downstream (refining & retailing). It mainly consists of pipelines and storage assets.

EPD August Presentation

Despite operating in the volatile energy space, EPD is well-protected from most of the fluctuations. The majority of EPD's revenue (80% in the first half of 2020) is derived from fee-based, take-or-pay contracts that require counterparties to pay a fixed amount regardless of the price of the commodity or the volume that passes through the pipeline or storage facility. This, combined with the mostly financially strong nature of EPD's counterparties, makes cash flows remarkably stable and predictable.

Of the remaining fifth of revenue, 16% was volumetrically based and 4% was based on commodity prices.

Importantly, 12% of natural gas revenues came from higher nat-gas prices, while 38% came from volumetric growth and marketing income. This gives EPD some exposure to higher sales from high nat-gas prices. More importantly, the high nat-gas prices make EPD's pipelines increasingly valuable if and when American producers ramp up production again.

Here's how EPD's gross operating income is broken down by business segments, using 2020's numbers:

• NGLs (natural gas liquids): 51%
• Crude oil: 24.4%
• Petrochemicals & refined products: 13.2%
• Natural gas: 11.4%

As you can see, EPD is primarily leveraged to natural gas rather than oil. Moreover, all major capital projects currently in development are related to either petrochemicals & refined products (77%), natural gas (16%), or NGLs (7%).

EPD's management have proven themselves to be excellent capital allocators, with an average return on invested capital of 12% over the last decade and with 100% of both the distribution and capital investment covered by operating cash flow over the twelve months from July 2020 through June 2021.

EPD August Presentation

As part of its conservative management, EPD maintains a strong, BBB+ rated balance sheet. The leverage ratio of 3.24x is below management's target of 3.5x. At the end of Q2, EPD also enjoyed an extremely long weighted average debt maturity of 20.8 years. That is even longer since EPD recently issued $1 billion of 31-year debt at a fixed, effective coupon yield of 3.33%.

Management also like to eat their own cooking, which is always a good sign. Nearly one-third of common units (~32%) are owned by management and directors, and co-CEO AJ Teague has been buying more as recently as September:

SEC Form 4

The biggest risk to EPD, and probably the reason it has sold off recently, pertains to potential political changes that could fundamentally disrupt the entire oil and gas business in the United States. The Ways And Means Committee's $3.5 trillion "reconciliation bill" currently under negotiation in Congress would institute several major changes to the energy space, such as a higher royalty rate for oil production on public lands, other penalties for fossil fuel companies, and incentives for offshore wind production, that could indefinitely impair EPD's business model.

However, with no room for Democratic defections in the Senate and two vocal Senate Democratic holdouts (Senators Manchin and Sinema), it remains to be seen what climate policies will actually pass both wings of Congress. Until some resolution is reached on the Democrats' legislative agenda, EPD's stock/unit price will probably remain rangebound.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CSWC, MAIN, DOC, EPD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.