Will Tax Hikes Slam Telecom ETFs?

by on September 9, 2010 | ETFs Mentioned:

Perhaps now more than at any point in recent memory, Wall Street is keeping a close eye on Washington. In the wake of the recent recession, government regulation and interaction has become a relatively frequent and significant source of risk to various corners of the U.S. economy. First a wave of uncertainty washed over the financial sector as Congress debated the severity of regulatory changes. Then the health care industry held its breath as it waited to see how landmark legislation would impact the profitability of various corners of that market. And most recently the energy industry has been in focus, as various responses to environmental disasters that could change the outlook for oil and gas firms float around Capitol Hill.

Next up: the telecom sector. Industry giants such as AT&T and Verizon, as well as smaller players such as Frontier, are reportedly stepping up efforts to fight the end of Bush-era tax cuts that have increased the appeal of securities delivering hefty dividend yields to investors. The fear is that a jump in the effective tax rate on dividends will cause investors to flee dividend-paying stocks in favor or securities that won’t incur such adverse tax consequences. If Congress doesn’t step in, tax cuts enacted under the George W. Bush administration will expire in January, and the tax rate on dividends would jump from 15% to nearly 37%. That would take a significant chunk out of dividend payments, and could significantly diminish the appeal of securities that make hefty dividend payments.

The Obama administration has indicated that it would prefer to tax dividends for wealthy Americans at 20%, the same rate that would be in effect for capital gains. But most suspect that no action will be taken until after mid-term elections in November. “The conventional wisdom in Washington is that Congress won’t act on extending the tax cuts until after the November elections,” writes Shayndi Rice. “But some political observers think Democrats may act sooner, especially if they want to counter Republican charges that they have irresponsibly raised taxes during a painful economic recession.”

Joining in the fight are a number of other dividend-paying companies, including Altria, Xcel Energy, and MassMutual Financial. The ultimate success of these companies could have an impact on a number of ETFs that focus on dividend-paying stocks [see Guide To Dividend ETFs].

Telecom ETFs In Focus

While many economists believe that the telecom lobby may be overstating the potential impact of a tax hike, the industry’s major players are clearly concerned that the expiration of the cuts could have a material, adverse impact on their stock prices. There are a number of ETFs offering exposure to the telecom sector, including eight in the Communications Equities ETFdb Category. Below, we profile three funds that could see their performance impacted by Washington’s ultimate decision over the Bush tax cuts [for more actionable ideas, sign up for our free ETF newsletter]:

  • iShares Dow Jones U.S. Telecom Index Fund (IYZ): This ETF, linked to the Dow Jones U.S. Select Telecommunications Index, counts among its top holdings several companies whose dividend yields are among the highest in the S&P 500 (including Frontier, which tops 9%). IYZ has about 35 holdings in total, with large and mega cap stocks making up the majority of holdings. This ETF charges an expense ratio of 0.48%.
  • PowerShares Dynamic Telecom & Wireless Portfolio (PTE): This fund is part of PowerShares Intellidex suite of ETFs, a line of products linked to “intelligent” benchmarks that utilize quantitative analysis to select components poised outperform peer stocks. Unlike IYZ and VOX, this ETF isn’t linked to a cap-weighted benchmark, meaning that weightings given to AT&T and Verizon are more moderate. PTE charges an expense ratio of 0.60% [also see ETF Plays On "Net Neutrality" Dispute].

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Disclosure: No positions at time of writing.