Utility Futility And Dividend Dumping: Are Tax Fears Overdone?

Includes: IYR, XLU
by: Alan Brochstein, CFA

When it became obvious to me in early September that President Obama would be reelected, I shared a series of preliminary ideas regarding portfolio positioning, focusing on minimizing interest-rate risk. One of the areas I suggested might come under pressure was utilities (NYSEARCA:XLU), as they generally don't have the earnings growth potential to boost their dividends fast enough to offset the higher required yield as interest rates rise. XLU has been hammered over the past eight weeks, with all of the YTD gains wiped out (click to enlarge images):

Like many things in life, it's better to be lucky than smart. While I had suggested that an Obama reelection would be viewed as inflationary and likely to put pressure on interest rates, the 10-year Treasury has actually declined from 1.87% to 1.61%. So, why are utilities under attack? Quite simply, it's fear of higher taxation. While it's far from certain how the taxation of dividends will change, it will rise unless Congress takes action.

Let's look at an example of what this would mean to an investor holding a typical utility stock (or any stock eligible for the preferential qualified dividend tax-rates) in a taxable account. Let's assume that the stock has a dividend yield of 4%. If this investor is in the top tax bracket, his after-tax yield is currently 3.4% (85% of 4%, reflecting a top rate of 15%). The tax-rate will more than double in 2013 to 39.6%, resulting in a after-tax yield of 2.42%. Ouch!

If an after-tax yield of 3.4% is how the utility reprices, the pre-tax dividend yield would have to rise to 5.63%. In this case, the price falls a stunning 29%. Given that XLU has dropped only 8.5%, this might scare you, but it likely shouldn't.

It's very simplistic to assume that the dividend yields should automatically adjust by the marginal tax-rate change such that the after-tax yield remains the same. First, not all utilities are owned in taxable accounts. Second, not all tax-payers are in the top bracket. Third, not everyone has been able to meet the 60-day holding period requirement. Finally, and most importantly, it's likely that utilities haven't been pricing in favorable taxation ad infinitum. After all, they were supposed to have ended in 2010 but were extended for an additional two years.

Rather than just assume that the market wasn't making a horrible mistake and allowing utilities to become significantly overpriced, let's examine the data. The S&P 500 utility sector has had a dividend yield over the past 20 years ranging from 2.7% to 6%. It is currently pretty much right in the middle, as you can see in the middle panel. Just from this perspective, one would have to conclude that the expiration of the favorable tax-rate may be priced in. But, we need to keep in mind that interest rates are historically low. All things equal, one would expect that utility dividends would be near their all-time lows, which we already see in the middle panel is not the case. In the bottom panel, this divergence really stands out. The ratio of the uility yield relative to the 10-Year Treasury is at an all-time high!

Now, to be fair, there may be a little bit more to the story. While the tax-rate change is freaking investors out, there are other issues likely playing a role. The sell-off may reflect the fear of regulatory wrath after excessive outages following Sandy. Additionally, there is a school of thought that regulators may push down allowable returns in a lagged response to the lower interest-rate environment. As further evidence, my examination of REITs and preferred stocks (neither of which is eligible for the qualified dividend tax-rate), both of which trade at much closer to their all-time low yields, suggests that the market has never expected the low tax rates to persist forever.

In terms of how an income-investor should react to the recent plunge, I have a few ideas. First, I have already highlighted my best idea regarding utilities, which I shared in late September when I discussed "11 Utility Stocks That Could Hold Up To Rising Rates." Dividend growth can stand up to the pressures of rising interest-rates, but it can also help offset the tax issue as well. This is because a greater portion of the value is in future years - the tax-hit up-front is less in lower-yielding faster-growing utilities.

Another issue to consider is that this dynamic goes well beyond utilities: It applies to almost any dividend-paying security. The higher the yield and slower the expected growth, the more pernicious a rise in tax-rates will be. I plan to follow up with a screen of high-yielding but slow-growing stocks that haven't reacted as negatively. Preliminarily, there are 41 non-utility stocks in the S&P 500 that yield more than 4%. Of these, 3 are up more than 10% this year and still within 6% of their recent highs.

Now, notice that I said almost any dividend-paying security. REITs have never been eligible for the favorable tax-rates. Interestingly, though, the sector is under pressure as well! iShares Dow Jones Real Estate (NYSEARCA:IYR) has dropped almost 7% over the past four weeks, slightly more than XLU. The after-tax yield for REITs will be dropping as well, but not as much, as the top tax-rate is increasing from 35% to 39.6%. This sell-off provides an opportunity potentially for tax-payers in the highest bracket to reallocate from utilities to REITs.

So, while I am not a huge fan of utilities given my views on interest rates and my expectations of above-consensus economic growth, the recent decline due to concerns over tax-law changes leaves me less negative. Given the divergence between XLU and bonds and the historically high yield of the former relative to the latter, investors, especially tax-exempt investors, should consider switching their allocation towards XLU or individual utilities and away from bonds. Additionally, taxable investors especially might look to the REIT sector. Finally, given that higher taxes seem to be driving the near-term performance, it may make sense to cull from one's portfolio any slow-growing, high-yielding non-utilities that may not have pulled back yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.