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It's early December, and dividend investors are already receiving holiday cheer. Some companies have announced they'll stuff our stockings with special dividends. But is the recent flurry of dividend-paying a good idea? Let's take a look at why the holiday binge may hurt companies long after the ball drops in Times Square.
The rushed merriment is in an effort to spare investors from a bigger tax hit in 2013. As it currently stands, taxes on dividends are scheduled to increase next year unless Congress wards off the fiscal cliff by extending Bush-era tax cuts. After we welcome the new year, qualified dividends will be taxed at an individual's marginal rate, up from the current 15%. Marginal tax rates will rise to 15%, 28%, 31%, 36%, and 39.6% in 2013, up from the current 10%, 15%, 25%, 28%, 33%, and 35%.
To save us the tax bite, several companies will pay fourth-quarter dividends to shareholders in December instead of the regularly scheduled January payout date. Other companies will gift shareholders with a special one-time cash dividend by year-end. Still others will shell out nearly all of their 2013 dividends this December. In fact, software giant Oracle (NYSE: ORCL ) recently announced that it'll pay its second-, third-, and fourth-quarter dividends for 2013 on Dec. 21 of this year.
In a previous article, I addressed one big reason for the early holiday joy: Major shareholders want to spare themselves tax pain. Insiders who own a large portion of company stock will hugely benefit from accelerated dividend payouts. For example, Wal-Mart's (NYSE: WMT ) Walton family -- who owns roughly half of the company's outstanding shares -- is projected to save $180 million in federal income taxes as a result of the early dividend, payable to shareholders on Dec. 27.
But there's something different about this most recent wave of dividends. With borrowing rates at rock-bottom lows, some companies are taking on debt to fund their special dividend payouts. In fact, according to The Wall Street Journal and Dealogic, corporate bond sales hit a record $105 billion in November.
Just last week, both Carnival (NYSE: CCL ) and Costco (NASDAQ: COST ) issued bonds for this very reason. Carnival sold $500 million of bonds after announcing a $390 million special dividend payable to shareholders on Dec.28. And the proceeds from Costco's $3.5 billion debt issuance will fund its $3 billion special dividend. This move represents Costco's first bond sale in five years. In leveraging up, Costco will triple its long-term debt.
Ratings agencies are taking note. Moody's, Standard & Poor's, and Fitch have all lowered the credit ratings of some companies employing this strategy. In the third quarter, Moody's downgraded the bonds of 27% of companies that took on debt to fund dividends, compared with roughly 15% of all companies during the same quarter. A company familiar with spreading more traditional forms of holiday cheer, spirits maker Brown-Forman (NYSE: BF-B ) got its credit rating knocked down after announcing a debt-funded special dividend.
However, companies with solid balance sheets -- like Costco's -- can get away with this strategy. Costco's long-term debt-to-equity ratio of 13% pales in comparison to Target's 114% and Wal-Mart's 73%. Sure, Costco's long-term debt will increase threefold. But even after the debt issuance, the extent to which the company is leveraged is still lower than its competitors'. The downside? It'll cost Costco (and other companies that choose to fund special dividends this way) more to fund debt down the road in the event the company runs into problems or wants to borrow money to expand or make acquisitions.
Foolish bottom line
Regardless of their methods for doing so, companies are delivering the holiday presents early this season. But is leveraging up to pay a special dividend or accelerate one a prudent move? I guess it depends on whom you ask. I'm just one shareholder critically thinking through a company's logic. Any Foolish investor would do the same.
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