One of the unintended yet positive consequences of the fiscal cliff is the looming incentive to return cash to shareholders now, while a lower rate on dividend income prevails, rather than waiting until next year, when the new rates could be punitive. Most dividend recipients are well aware that, on Jan. 1, the tax rate on dividend income will jump to at least 18.8% -- the current rate, plus a scheduled 3.8% surtax on high incomes. However, Congress could reclassify dividends as ordinary income, thus pushing the highest marginal rate of taxation up to 39.6%. That is only federal, of course!
Some enlightened boards of directors have noticed this risk, and are acting now to return cash to shareholders. The result has been a trend of special dividends being paid before year-end, and we can expect that trend to accelerate in the weeks ahead, especially if President Obama wins the election. Here are some of the recently paid and upcoming specials.
The upcoming dividends from Transdigm (TDG), Diamond Offshore (DO), A.H. Belo (AHC) and Progressive (PGR) look good. This is because they are large enough to be attractive, but not so large as to seriously distort the trading in a stock.
Iron Mountain (IRM) provides an example of how to play large dividends, which cause the price to drop precipitously on the ex-dividend date. If you had bought Iron Mountain stock on last close before it went ex-, you would have paid $37.69. The next day, the stock dropped to $33.78, a loss of $3.91. Meanwhile, you would have collected $4.0614, so you would have had a net profit. On Friday, despite the carnage in the market, the stock closed at $34.08. If you sold Friday afternoon, you would have booked a loss of $3.61, which netted against the dividend offers a profit of $0.4514, or 1.2% of your purchase price.
That's not bad for two days of "work." The key, of course, is not to wait for Iron Mountain to get back to the old price, which could take weeks or months. If you have a solid total return on the trade, book it (sell the stock) and move on to the next idea.
While we equity investors can reap the benefits of increased cash flow, bond-buyers should be careful. Low yields and the tax cliff are causing many leveraged buyouts and private-equity deals to pursue levered recapitalizations. Many are selling junk bond offerings with payment-in-kind interest, then paying out big dividends to the owners. This is feeling uncomfortably like the late 1980s, especially after last week's 25th crash anniversary and the (hopefully) sympathy selloff we threw to celebrate it. I am an equity guy, so I don't care that much how special dividends are financed, but all our fixed income readers should double check "use of proceeds."