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.