I had dinner a few weeks back with an old friend, a very bright and accomplished woman, very good at managing things, four kids, a divorce, creating and selling a business — you get the picture. She asked me a couple of questions about her stash — her capital — and whether it would be enough to generate the income she wanted if she retired completely.
I gave her answer in two parts – yes, you will have enough money, if the tax code stays the same and you get a good yield on your capital. “Perhaps” — if the tax code does not stay the same.
And that pretty much sums up why many consumers and most businesses have pulled back on serious spending: They do not know what they will owe Uncle Sam when he comes to the door and asks for money. The business slowdown is becoming dramatic, having begun in April and gaining steam as the fiscal cliff and decisions on tax policy — or a lack thereof — get closer and closer. For individuals, the best approach is one that lets you relax — and that means getting yield now but hedging for any possible change in policy. Especially the treatment of dividends.
Theoretically, the preferable treatment of dividend income goes away on Jan. 1. That may or may not be changed. We do know a 1% or so Medicare tax on unearned income – dividend income – takes effect on Jan. 1 and that is here to stay. Your 5% return on that utility stock just got a smidge smaller. If the preferential treatment of dividend income goes away and stays away, your yield will decline dramatically — and dividend stocks will take a big hit.
Or will they?
Tax treatment for dividends
There are two theories about what happens if dividends are treated as ordinary income. Theory No. 1 believes investors will flee the stocks and there will be a selloff. Given that many high yield stocks are at or near all time highs, this theory has merit. Theory No. 2 says investors want certainty even more than they want a specific amount of yield, want the certainty of a dividend and will not only stay in dividend stocks and funds, they will chase those with the highest yields to make up for the hit they take in taxes.
I am a Theory No. 2 advocate. Everyone wants a steady stream of cash and does not want to rely on appreciation of stock to pay the rent or mortgage. But what if am wrong?
Do one of two things. Option one is to buy puts on your high-yield names, and that will cost you at least a couple of percentage points of what they are yielding. This works for truly high-yielding names with a 10% yield or more.
For example, if you own Annaly Capital (NLY), now trading around $16.90 with a near 13% yield, you can buy a $16 put that expires in November for around 12 cents. If that expires worthless, you do it again, buying a put every two months, six times a year. That has a cost of 72 cents out of a dividend yield of $2.21, reducing your yield to around 9% but giving you downside protection.
Option two is to sell calls on your high-yield stocks and ETFs and use the cash to buy puts. This reduces or eliminates the upside potential for the stock but gives you downside protection.
For example Verizon (VZ) yields just less than 5% and is trading around $45.80. If you sell a November $46 call you can use the cash – around 64 cents per share – to buy a $44 put for around 53 cents. And pocket some cash. You have downside protection beginning at $44. You also pocket around ten cents every two months or 60 cents a year. That boosts the yield from around 5% to 6.3%.
We now live, every day, with uncertain markets due to a growing dependence on unpredictable public policies. Think about hedging to get rid of that uncertainty.