Investors clamoring for dividend income

After a brief year-end disruption related to the fiscal cliff negotiations, the hunt for dividend income is back on with a vengeance.

“Right now, the money is flowing into our rising-dividend fund at a record rate of more than $1 million a day,” said George Schwartz, president and chief executive of Investment Counsel Inc.

He co-manages the $317 million Ave Maria Rising Dividend Fund (AVEDX) along with Rick Platte.

Over the past few years, the extended stretch of record-low interest rates has spawned a growing appetite for dividend income, which is illustrated by the more than $17 billion in net asset flows into dividend-focused mutual funds last year, according to Morningstar Inc.

But even though the monthly net flows for the first 11 months of 2012 ranged from $775 million to more than $3 billion, the threat of higher taxes on dividend income trimmed net flows into the funds last month to $159 million.

What has changed since December is that the threat that dividends would be taxed as ordinary income was alleviated by the fiscal cliff deal. The tax rate on dividend income jumps to 23.8%, from 15% last year, for households earning more than $450,000 annually, or $400,000 for a single person.

A BONUS

The new rate, which includes a 3.8% tax on investment income to help pay for the health care law, is considered a bonus compared with the new top ordinary income tax rate of 39.6%, up from 35% last year.

The health care law tax kicks in for households making $250,000 annually, or $200,000 for singles, adding up to an 18.8% tax on dividends and capital gains at those income levels.

“At the end of the year, people were unloading their dividend payers, but a lot of that has since snapped back, and dividend stocks have started to resume their strong performance,” said Jay Wong, who manages the Payden Value Leaders Fund (PYVLX) at Payden & Rygel, a $65 billion asset management firm.

Categorywide asset flows for January are not yet available, but the average return of the roughly 400 dividend-paying stocks within the S&P 500 since the start of 2013 is 3.5%.

By comparison, the average return of non-dividend-payers over the same period is 3.2%.

Dividend-focused funds tracked by Morningstar produced an average return of 13.6% last year and 3% so far this year. The S&P 500 gained 16% last year and 3.3% so far this year.

Clearly, studying just the first two weeks of January is a small sample, but the recent performance of the dividend payers does represent a stark reversal from 2012, when non-dividend-payers in the S&P 500 beat dividend payers by an average of 2%, according to Mike Boyle, a senior vice president at Advisors Asset Management Inc.

“Our message throughout the year was that dividend stocks have historically been successful in all tax environments, but the long and short of it is that dividend payers might have underperformed last year due to fears of higher taxation,” he said. “I think what we’re seeing now is some pent-up demand.”

And in one of the higher-profile examples of how corporations were anticipating a rising tax on dividends, Costco Wholesale Corp. (COST) famously borrowed $3.5 billion in order to issue a $7-per-share special dividend at the end of 2012.

According to Mr. Boyle, over the past 42 years, dividend payouts from S&P 500 companies have grown by an average annual rate of 5.9%.

Last year, however, thanks largely to the actions of companies such as Costco, dividend payouts in-creased by 18% over 2011.

“EXCITING PLACE TO BE’

“Our guess is that we will probably see that growth rate come down a bit this year,” Mr. Boyle said. “But it’s still an exciting place to be, because a lot of people have been sitting on the sidelines, and as they move back into the market, it is usually into dividend stocks.”

But record-low interest rates and less-than-expected tax consequences aren’t the only factors favoring dividend stocks right now.

“I think 2013 is going to be a volatile year in the markets, and high volatility is good for dividend stocks because investors tend to get more risk-averse,” said Matt McCormick, portfolio manager at Bahl & Gaynor Investment Counsel Inc., a $7.6 billion firm that specializes in dividend investment strategies. “Dividend stocks traditionally outperform when volatility is up.”

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