3 hidden risks for dividend investors

Watch bonds, interest rates, regulation.

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There are good reasons why investing in dividend stocks has become so popular, but I’m with MoneySense columnist Dan Bortolotti and Steadyhand Funds president Tom Bradley when they urge caution about going overboard on a good thing.

In addition to the points they make, I would add another consideration. In my view, the enthusiasm for dividend stocks reflects to a large extent a rather supportive environment. With interest rates on bonds and GICs so low, the search for yield often ends up with dividends yielding 3% or more. Plus, up to $50,000 in annual dividend income can be earned tax free, and no systemic shocks have occurred recently to remind us of the merits of diversification.

But such a dividend-friendly environment can’t last forever. Indeed, we appear to be transitioning to a less supportive setting. Let’s look at three aspects of the shift now in progress and how dividend stocks could be affected. 

1. Rising interest rates

The massive monetary stimulus now being meted out by central bankers should at some point trigger a business upturn, which, in turn, should start an upward cycle in interest rates. That’s because bond holders will start selling down their positions as the flight to safety goes into reverse and inflation fears edge upward.

Rising interest rates increase the attractiveness of bonds vis-à-vis dividend stocks, so there will be some rotation out of dividend stocks. At the same time, cyclical and growth stocks will be enjoying relatively strong earnings growth and siphoning funds away. In short, prices for dividend stocks could find it tougher to keep up, resulting in lower total returns (capital gains + income) than the broader market on a secular and cyclical basis.

2. Higher taxes

The favourable tax treatment of dividends may be at risk, especially when governments are looking for revenues to pay down their Mount Everest of financial obligations. In fact, the likelihood of higher dividend taxes is now very real in the U.S. thanks to the “fiscal cliff” of automatic tax increases and spending cuts. Currently at 15%, the tax rate on dividends could soon jump by as much as 43%.

The impending reduction in after-tax returns for taxable accounts is taking some of the shine off. Typical of those selling is New York University professor Aswath Damodaran, who wrote Sept. 27 in his blog: “…the dividend cliff scares me and …. I will continue pruning my portfolio, shifting my money from large dividend-paying U.S. stocks to non-dividend paying or low-dividend paying foreign stocks.”

Analysts also note that a less favourable tax treatment will prompt many corporations to de-emphasize dividends. Specifically, the rate of dividend growth may be dialled back so earnings can be diverted into repurchasing company shares (a more tax-efficient way of boosting shareholder value).

The taxation issue has also surfaced in Quebec. The newly installed Parti Québécois has announced plans to cut the provincial dividend tax credit in half. Replenishing government coffers has taken priority over the avoidance of double-taxation of dividends.

In sum, as the U.S. situation illustrates, a rolling back of tax breaks on dividends at some point in the future cannot be ruled out in Canada. Moreover, what’s happening now in Quebec shows what could lie ahead in other provinces.

3. Diversification

Many dividend investors focus on Canadian stocks, so their portfolios are concentrated in the financial, utility and telecom sectors. This limited diversification heightens exposure to “tail risks” such as financial turmoil and sweeping regulatory changes—which tend to see higher probabilities of occurrence during trend reversal periods. For example, if the central banks’ attempts at reflation inadvertently tip the “bond vigilantes” into panic selling, the consequent upward spike in bond yields could potentially be in the same order of trauma as the financial crisis of 2008.

Conclusion

Dividend stocks have a place in portfolios. But as with all good things, there is a danger of taking on too much risk by loading too heavily on a certain factor. Some investors have high risk tolerances, so they can live with high weightings. For others, a more diversified portfolio will help smooth out the ups and downs.

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