Are High-Dividend Stocks Doomed?

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The fiscal cliff is dominating the headlines, and given the slow pace at which the government moves even in crisis mode, you can expect it to stay in the news for quite a while. But beyond the obvious big-picture issues at stake, including potential tax increases on just about everyone who pays any income tax at all, certain favorite stocks among dividend investors are getting absolutely hammered.

Mortgage REITs and master limited partnerships both enjoy special tax treatment that benefits their investors. Because they don't have to pay corporate tax, they pay out more income to their shareholders. Yet these investments face a potential double hit from any resolution to the fiscal cliff: higher potential taxes on their dividends plus the threat of having their favorable tax status made a thing of the past.

The highest payouts in the land
Mortgage REITs have a long history of producing amazing, almost unbelievably high dividend yields. With some mREITs having paid 20% yields or more, investors didn't really need to see any increase at all in share prices to count their investments a roaring success.

But news earlier this week that Annaly Capital (NYSE: NLY  ) planned to buy commercial mortgage debt-holding REIT Crexus Investment sent shares of Annaly tumbling, as well as the stocks of mREIT peers American Capital Agency (Nasdaq: AGNC  ) and ARMOUR Residential (NYSE: ARR  ) .

For Annaly, a stock drop may have made sense. After all, companies that pay a premium for acquisitions often see their shares fall after an announced deal. But the collateral damage that worked its way across the industry suggested a much greater issue, one that some analysts extended to a paradigm shift for the mREIT space as disruptions like the Federal Reserve's focus on mortgage-backed securities in its latest round of quantitative easing start to affect their ability to do business profitably.

Dividend taxation is only one element of what's happening to mortgage REITs. Although low interest rates are likely to persist, the logjam in the mortgage market that has prevented millions of homeowners from refinancing may not last so long. That would spell trouble for mREITs regardless of their tax status or what their shareholders pay in taxes on dividends.

Feeling less energetic
Master limited partnerships have also been the target of scrutiny from tax policymakers in the past. Companies that do business in producing or transporting certain types of natural resources qualify for MLP status, which allows them to operate outside the corporate tax realm yet remain publicly traded. Moreover, because MLPs often have cash flow in excess of their taxable net income, the distributions that MLP unitholders receive are often free of income tax -- at least until you sell shares, at which point some of those returns of capital are recaptured for tax purposes.

Lately, many MLP shares have dropped precipitously. Kinder Morgan Energy Partners (NYSE: KMP  ) and Enterprise Products Partners (NYSE: EPD  ) both specialize in pipelines and other midstream operations, and both pay their shareholders well, with yields in the range of 6% to 8%. But they've both fallen more than 5% in the past week. Various Dow Jones-owned news sources suggested the possibility that the federal government would take away favorable status for MLPs, removing a big part of their appeal.

Again, though, other factors are in play. Even as the weather gets colder, natural gas prices have only regained a small portion of what they've lost in recent years. Even with a new potential crisis brewing in the Middle East, crude oil prices remain subdued. With so many investors having gotten into the sector due to high yields, MLPs may well simply be primed to take a break in their long bull run.

Don't be paranoid
With these high-yielding investments all in the doldrums, it's tempting to blame the fiscal cliff and its impact on dividend tax rates as the culprit. But in both cases, you'll find other, more fundamental reasons why each respective industry is having its problems. As a result, it's reasonable to expect that if fortunes turn around for those industries, their stock prices should recover as well -- even if the fiscal cliff takes a while to resolve.

To learn more about the business model that Annaly Capital has used to produce such stellar dividends, check out our premium research report on the mREIT. You'll find out our analyst's opinions on whether Annaly is a buy, along with other must-know topics about the company and the future opportunities and pitfalls of its strategy. Click here now to claim your copy.

Read/Post Comments (4) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 15, 2012, at 10:36 AM, generics wrote:

    REIT dividends are taxed like interest income, not tax-advantaged dividends, so the taxation argument is irrelevant.

  • Report this Comment On November 15, 2012, at 10:37 AM, chopchop0 wrote:

    The selloff makes no sense. The MLP dividends are DISTRIBUTIONS, which are not treated as qualified dividends for tax purposes.

    Regardless of what happens, they will continue to be taxed at the ordinary income tax rate.

    Regarding the possible change to MLPs, I can't opine on that, but with this administration, I guess anything is possible. Nonetheless, the long-term outlook is great for these midstream pipeline companies and I am slowly adding at these levels

  • Report this Comment On November 15, 2012, at 11:28 AM, TimTebow wrote:

    1) as stated above these are non-qualifying dividends, if anything that should warrant a buying opportunity

    2) Average annual cost to the federal government of MLP tax breaks is only $300 million...enough to stall the growth of the deficit by a whopping 2hrs

    Please stop posting stuff like this as I'm sure people are buying into this nonsense and selling dividend stocks out of misguided fear...

  • Report this Comment On November 15, 2012, at 2:08 PM, TMFGalagan wrote:

    @generics, @TimTebow - The fiscal cliff issues aren't irrelevant to mREITs because ordinary tax rates are slated to go up. Granted, they don't typically qualify for the 15% maximum rate so it isn't as egregious as with other dividend stocks that do qualify.

    The key point, though, is if mREIT status itself is revoked, added taxation at the corporate level will make a huge difference. That's also the case if MLP status is revoked.


    dan (TMF Galagan)

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