Dividend Seekers - Beware!

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With investors forced to accept extremely low yields on their fixed income products, many investors hungry for yield are beginning to explore new fields of investment. One field that is worth mentioning is the Master Limited partnerships, or MLPs. A master limited partnership (MLP) is a publicly traded limited partnership. Shares of ownership are referred to as units. MLPs generally operate in the natural resource, financial services, and real estate industries. 

The candy

The big advantage of MLPs is that they are not subject to income tax. This means that more cash is available for distributions than would be available had the company incorporated. This generally means that the dividend distribution rate of MLPs is much more favorable than other comparable companies. This also makes MLP units worth more than similar shares of a corporation. Take, for example, a few ETFs that track MLPs, and their current yield:

  1. ALPS Alerian MLP ETF (NYSEMKT: AMLP): 6.20% yield.
  2. Yorkville High Income MLP ETF (NYSEMKT: YMLP): 7.72% yield.
  3. Global X MLP ETF (NYSE: MLPA): 6.07% yield.

With these mouthwatering yields, it is no wonder why investors have been attracted to this type of investment in the first place. It can easily beat almost any fixed income investment empty handed.

 

A possible imminent danger to your dividends

President Obama based his reelection campaign on raising taxes on the wealthy. He's also been adamant about letting the Bush-era tax cuts expire on January 1, 2013. One of those cuts includes the rate charged on dividends. Today, the tax rate on dividend income is 15%. If this expires, the dividends would become ordinary income and subject to tax rates up to 39.6%. That would significantly reduce the rate of return on dividend-paying stocks like MLPs. 

It is imperative to understand that because MLPs do not retain their earnings but instead - deliver them back to shareholders in the form of dividends, they are bound to face strong selling pressure should their dividend policy suddenly become less appealing overnight due to this possible tax burden.

The psychological effect

Investors tend to fall in love with their dividend paychecks. The regularity and sustainability of payouts to shareholders make shareholders addicted to them. This, in turn, causes them to ignore any upcoming risks to their dividends. They simply refuse to acknowledge it. This strong psychological bias towards dividends usually ends up with a strong selling pressure once any doubts arise as to the possibility of elimination of the dividend.

Take Annaly Capital Management (NYSE: NLY), for example. Annaly is a mortgage REIT which makes its money by trading the interest rate curve. Because of its incorporation as a REIT, it is obligated to return 90% of its profits back to shareholders in the form of dividends. Many investors are hooked on Annaly because of its tempting dividend rate, currently at 13.5%. But guess what happens once a dividend cut becomes a possibility? The stock can easily dive like a rock.

<img src="http://chart.finance.yahoo.com/c/3m/n/nly?lang=en-US&region=US" />

The Foolish conclusion

It is imperative to understand that I do not recommend that you sell all of your dividend stock holdings. This will probably be a mistake. The main point here is to make you focus your attention on a possible red light down the road. Prepare accordingly.


shmulikarpf has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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