Investing Insights: Dividends, TIPS, and Tax Deductions

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Karen Wallace: After laying low in 2015 and 2016, inflation rose 2.8% over the last 12 months. Here to discuss how inflation-protected bonds work and the role that can play in a portfolio is Eric Jacobson. He is a senior analyst on our fixed-income manager research team.

Eric, thanks so much for being here.

Eric Jacobson: Thank you. Glad to be here.

Wallace: Let's start by just discussing what TIPS are and how they work.

Jacobson: TIPS are bonds with an inflation protection built in. The way that that works is, their underlying prices are indexed to the CPI, the Consumer Price Index. The idea is as the CPI goes up, eventually their prices should follow.

Wallace: What are some of the risks of TIPS? People say this is a risk-free asset, but what does that mean?

Jacobson: They aren't exactly risk-free, because they are bonds and they do have sensitivity to interest rates. In other words, as yields move up, for example, the price of TIPS can go down. Now, people think that they are risk-free because their end payment or the maturity value is going to be indexed to inflation, and you can't get less than you paid for them. Along the way the price can go up and down quite a bit. They tend to be very long-duration, long-maturity instruments, and the price can swing up and down all around which they do, and they are pretty rate-sensitive.

Wallace: Even the inflation-protected feature isn't guaranteed if you sell it before maturity?

Jacobson: That's right. The underlying principal value will probably creep up a little bit every year as long as we have some inflation, which is what we get. Instead of being $1,000, the underlying principal value will go up, maybe $1,200, $1,300 over a long period of time. But on a day-to-day basis, they are going to trade like other bonds. If it has a 3% coupon and yields move up 25 basis points or 50 basis points, the price is going to go down and that's going to happen quickly. They tend to be pretty volatile depending on how long maturity they are.

Wallace: TIPS might not be something that every investor needs. Some people may say, I have a lot of equity exposure; I'm protected from inflation through that. Who do you think TIPS make sense for and what role should they play in a portfolio?

Jacobson: That's a good point in that there are investors who feel very comfortable with their equity investments, that over a long period of time they are going to protect them from inflation. But there are a lot of people that want more balance in their portfolio. The nice thing about TIPS is, you are definitely going to at least pace with inflation with a TIPS bond. The other thing is that when there's a crisis and when other assets are getting killed because they have a lot of credit risk or equity risk and so forth, TIPS will generally hang in there pretty well. It's not all the time. They are not as liquid as regular treasuries, but they are government-backed bonds. They are a source some stability and safety. Even if they can be pretty volatile in the short-term, long-term they are a very good inflation hedge.

Wallace: What are some of the inflation-protected bond funds that we recommend? What are some of the strategies that are best-of-breed?

Jacobson: There's a couple that we like a lot. The first one is Vanguard Inflation-Protected Securities. Like a lot of other Vanguard funds as you'd expect, it does have some active management, but the TIPS market is very efficient relatively speaking, and there's not a lot you necessarily want to do. It's a pretty plain-vanilla fund and it's really, really cheap. That's one we like a lot.

The other one is PIMCO Real Return. Much like other PIMCO bond funds, they have sort of a base level of exposure to TIPS, and then they have some different techniques that they use to try and add to the returns of TIPS. Depending on which kind of PIMCO Real Return Fund, there's a couple of varieties--some of them use commodities; some of them use short-term bonds that they layer on the top of it. That fund tends to be a little bit more volatile than most of the other TIPS funds. If you figure that you are going to hold something for a very long time and you want to try and get a little bit more return, that's the one to go with.

Wallace: Eric, thanks so much for being here today to discuss this.

Jacobson: I'm glad to be with you. Thanks, Karen.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

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Damien Conover: We are talking about dividends in the healthcare sector today. When we think about dividends within this sector, most of the companies that are going to be paying dividends are in the large-cap pharmaceutical or large-cap biotechnology space. Most of these dividends in their history have been very, very safe, and we think that's very likely to be the case going forward. These firms generate enormous amounts of cash flows and can really support strong dividend payouts.

A couple of names we want to highlight as far as stocks that we think are both undervalued and have strong dividends are, first within the pharmaceutical space, will be Pfizer. Pfizer is a name that has a nice growth potential, not a lot of patent losses, and is really set up well to pay out a continual stream of dividends. This is a firm that we think is undervalued and underappreciated with a very strong pipeline. That pipeline will really help the firm be able to generate that future cash flow that will be needed for the dividend.

Another name within the pharmaceutical-biotech space is Roche. Roche is a name, we think, is significantly undervalued, paying out a nice dividend. What we think investors miss here is really the recently launched products. A very strong lineup in oncology, a strong lineup in multiple sclerosis, two areas that have very strong pricing power. The strong pricing power will enable very strong cash flows into the future and a very strong dividend yield for this firm.

One other firm we want to talk about within the pharmaceutical landscape is Allergan. Allergan, we think, is significantly undervalued and has strong growth potential from products already launched and a franchise within Botox that we think will not be disrupted by competitive threats.

Now, outside the pharmaceutical landscape, there are a few other areas that look interesting to us still within healthcare that pay strong dividends. The one that we are highlighting is Medtronic. Medtronic right now, we think, is somewhat out of favor because it's a little bit behind its innovation cycle with its new products. Nevertheless, Medtronic is very well-positioned in working with hospitals to provide value-add services. These services and products should really enable the firm to drive strong cash flows and again, support a very good dividend into the future.

Again, when thinking about overall dividends, these are a few areas, we think, are best-positioned within the healthcare sector.

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Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the new tax laws fewer taxpayers are likely to benefit from itemizing their deductions than in the past. Joining me to discuss the implications of this is Tim Steffen. He is director of Advanced Planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Thanks, Christine.

Benz: There's a lot changing in the tax code beginning in 2018, but I want to focus specifically on deductions today. Let's talk about the key changes in terms of deductions, standard versus itemized and so forth.

Steffen: Some big changes in the way taxpayers will go about calculating taxable income this year. You've got the standard deduction, which is the flat amount that all taxpayers can use to reduce income. That amount has essentially doubled for all taxpayers, not quite but pretty close. You've also repealed the personal exemptions, but that's a separate issue.

The other side and the deduction side is the changes to the itemized deduction. For those who don't take the standard, you've got itemized, which is this group of various expenses you can take deductions for, things like, income taxes, and mortgage interest, and property taxes, and charitable contributions, all of those things. Some fairly big changes on that side.

On the tax side, state income and property taxes in 2017, you could deduct everything you paid; in 2018, you are limited to $10,000.

Benz: Which is a big deal for people in high-tax states, right, or where there's high property taxes and sometimes those are the same states?

Steffen: Or people who own multiple pieces of property, or maybe had two or three homes or other pieces of real estate where they were deducting the taxes, those deductions are all going to be limited now to that $10,000 cap.

The other big one that was repealed is this whole category of miscellaneous expenses. Things like tax preparation fees and investment expenses and unreimbursed business expenses and union dues and all of those types of things. Those were all deductible under this category of miscellaneous deductions. Those are all gone now, or at least, temporarily. All these changes are all set to be repealed after 2025. We will see what happens when we get there. But for now, so that whole category of expenses is gone.

Other changes, they expanded charitable contribution slightly; mortgage interest, some changes there, but more for new homebuyers. Existing mortgages will generally be the same as they were before other than home equity loans. But all in all, it's fair to say that most taxpayers will have fewer itemized deductions in 2018 than they did in 2017, all things being equal.

Benz: Let's talk about the itemized deductions that you were just talking about. Accountants like you sometimes call those below-the-line deductions and those stand in contrast to above-the-line deductions. Let's talk about the differentiator between the two.

Steffen: You've got these two different groups of expenses, what we call, above-the-line and below-the-line. First of all, let's define the line. The line is what we call adjusted gross income. If you can visualize your tax returns, the last number on the front page of your 1040 or the first number on Page 2, that's the income number after certain adjustments that you are able to claim.

There is a certain group of expenses that are called the above-the-line deductions that all taxpayers can claim regardless of whether you itemize or take the standard deduction later on. These are going to be things like IRA contributions, SEP contributions, health savings account contributions, alimony to the extent that you are still claiming deduction for alimony and a number of other expenses that fall in that category. Those are all the above-the-line ones that reduce gross income down to adjusted gross income. And again, everybody gets those deductions if you have one.

Benz: We are not seeing major changes to those, correct?

Steffen: No real changes to those, other than maybe the alimony one beginning next year. But otherwise, yeah, no real changes there.

All the other things we talked about, the itemized deductions, those are all considered below-the-line, and you take those either the itemized or the standard deduction.

Benz: oome people might hear that and think, OK, I can stop saving my receipts if I am not going to be worrying about itemizing. What do you think? How should people approach that question of whether they will be an itemizer in a given year or claim the standard deduction?

Steffen: IRA statistics in the past have shown that roughly 70% of taxpayers take the standard deduction, and that's been pretty consistent for the last several years. That's the 2016 number as well. The estimates are now that when you combine the larger standard deduction with fewer itemized deductions, up to as many as 90% of taxpayers will now take the standard deduction, which means, fewer people having to go through the effort of collecting all those receipts and everything. They will be using the standard as opposed to the itemized. But it also means that they may look at some of those expenses they've got and say, well, I'm not taking a benefit for them anymore. They are maybe not as valuable to them anymore. They have got to rethink maybe some of the expenses that they have been paying and what the tax treatment is of those.

Benz: One strategy you have written about is to think about bunching those itemized deductions to try to gather them into a single year. I think people might hear that and say, well, things like medical expenses, don't have a lot of control over them. But how can people approach that question and potentially itemize in some years?

Steffen: With the larger standard deduction, let's say, you've got somebody who had maybe $20,000 of itemized deductions in 2017. They would take a deduction with those expenses. In this year, that married couple, the standard deduction is $24,000. All those itemized deductions they were claiming, they are not going to get a benefit for it anymore. They are going to get the flat $24,000. Does that mean they would stop paying some of those expenses? Well, you know, you can't really stop paying your state income and property taxes. States won't like that. You can't stop paying the interest on your mortgage because the bank isn't going to like that. Things like medical expenses you said, you can't really not pay those. If you are sick, you got to pay them.

But charitable contributions is the big one that I think people have the most flexibility with and are maybe the most likely to rethink if they know they are not going to get a tax deduction for it or if the deduction is maybe not what it once was. For those who are going to find themselves falling from itemizing to standard, they may look at those charitable expenses and say, I don't get a tax benefit for those anymore, maybe I don't need to make those anymore. If they were doing it for strictly tax purposes, that reason is gone now for some taxpayers.

Benz: The strategy though would be to think about if you are charitably inclined and you want to make a significant contribution to a charity or a group of charities, to maybe hold on to those for a single year and get the bang for your buck in terms of itemized deductions. How would that work?

Steffen: Let's say, you make a little bit of charitable contributions every year, but just enough that you can't quite get over that standard deduction, that $24,000. Instead of making all your charitable contributions every year like you normally do, maybe you hold off on making any donations here in 2018, defer them all to 2019. In 2018, your itemized deductions would fall but you are still below the standard deduction, so you continue to claim that. In 2019, however, by doubling up your charitable gifts now you've gotten yourself above the standard deduction and you actually get to itemize, you get a tax benefit for those gifts. Over the two-year period you haven't paid any more in expenses or any more charitable gifts than you otherwise would have, but in one year you took standard deduction, the next year you itemized. That's the concept of bunching. Bunching is a technique. It's been around forever. We've always talked about this. But with these changes in rules, it's really come into the forefront again and it's really a planning opportunity people are talking about now.

Benz: Let's talk about how a donor-advised fund can fit in with this bunching strategy for charitable.

Steffen: Let's say you are someone who is going to double up on your charitable contributions, maybe you defer this year's into next year. The charities don't necessarily like that because they lose that year of revenue with it. They go a year without getting any gifts. You may say, well, I don't want to harm the charity. Instead of going doubling up next year I will double up this year and do all my gifting this year. But then you say, well, maybe I don't necessarily know who I want to give all the money to yet or I don't want to give it all to the charity this year, I still want them to have some this year and next year.

One of the techniques that really plays into this whole bunching thing is the donor-advised fund. And donor-advised funds have been around for a while now. They have been a great planning tool for a long time. But the way those work is you put money into the account, think of it like a miniature private foundation. You fund the account today, you get the tax benefit today. The money is in the account. You can invest it, you can earn more money. And over time, you give it out to charity as you see fit. You can't reclaim the money. It's a completed gift. You get the tax deduction for it, but you can decide who to give the money to charities to over time.

In this bunching technique then you would double up on your charitable contributions now, in 2018, and then you use that, say, maybe you give your 2018 and 2019 contributions all into the fund now, then over the next two years you write checks out of that fund to the charities. From the charity's standpoint, they don't know any difference. They are getting the same amount, but you as a taxpayer have gotten the tax benefit upfront and you have been able to itemize. In the next year, you won't have any charitable gifts, you would go back under and take the standard deduction.

That's where the bunching and the donor-advised fund really kind of play into each other.

Benz: Another neat thing about donor-advised funds is that you can actually put securities into them, right? If you have something that's maybe illiquid, some sort of company ownership, you can put that in the donor-advised fund. The entity managing it knows how to deal with that.

Steffen: Exactly, yes. Donor-advised, because again, they are kind of like a private foundation. You work with another entity to manage it and they will tell you whatever they are willing to accept and most of them are willing to accept not only cash but stock shares and mutual fund shares and some will even take more illiquid property like artwork or vehicles or something like that would be fine, some of the more sophisticated ones. You can give those appreciated assets to the fund just like you would if you were giving a right to the charity. But now it's inside the donor-advised fund. That fund may end up selling that asset or they will work with you to decide how you want to manage that. But you can get the same tax benefit from giving appreciated stock to a donor-advised fund as you would if you give a right to the charity itself.

Benz: Whole new world here in terms of the tax regime. Tim, thank you so much for being here to discuss some of these strategies.

Steffen: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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Karen Wallace: New Morningstar research suggests that taking an indiscriminate approach to dividend investing can be risky. Here to discuss the findings is Dan Lefkovitz. He is a strategist in our Morningstar indexes group.

Dan, thanks so much for being here.

Dan Lefkovitz: Great to be here, Karen.

Wallace: One of the takeaways from your research is that investors can reduce the risk of investing in a dividend trap or a company that's likely to cut its dividend by focusing on a few metrics. What were a few of the metrics?

Lefkovitz: My colleagues and I in the indexes team at Morningstar looked at the predictive power of economic moat and distance to default on dividend sustainability. The Morningstar Economic Moat rating is assigned by our equity analysts. A company with a moat around its business is able to sustain its profits and fend off competition. Distance to default is a measure of balance sheet strength. It gauges the likelihood of bankruptcy. It looks at leverage and volatility and gauges whether the sum of a firm's assets are at risk of falling below its liabilities. We found that the wider the economic moat and the better the distance to default score, the less likely for a firm to cut its dividend.

Wallace: In 2010, Morningstar launched the Dividend Yield Focus Index. Can you discuss the methodology and how that index targets sustainable yields?

Lefkovitz: We designed that index in the wake of the financial crisis. A lot of dividend strategies ran into trouble, whether they were active or rules-based passive strategies, ran into trouble in the financial crisis relying exclusively on backward-looking metrics, dividend history, dividend growth history, metrics like the payout ratio. They weren't able to forecast the future. We designed Dividend Yield Focus to be explicitly forward-looking in nature and we employed these proprietary measures, the moat rating and distance to default.

Wallace: The original study that you conducted on this topic was done on U.S. companies. But you recently, when you redid the study, you looked at a global landscape. Do you see similar trends in global markets?

Lefkovitz: Yeah, we do. In the years since 2010, dividend yield focus has been successful and we've expanded it. We have a globalized family to incorporate markets outside of the U.S. Dividend investors have a lot of great companies to choose from, from a yield perspective, outside of the U.S., and yields are often higher in foreign markets. We tested the ability of economic moat as well as quantitative extension of the moat rating that uses machine learning algorithm to replicate the analyst work, the quantitative economic moat rating, as well as distance to default. We found that the trend held across markets--that the wider the moat, the better the distance to default score, the more likely for a company to sustain its dividend.

Wallace: You also looked at the relationship between dividend-paying securities and interest rates, and you found a few surprises there.

Lefkovitz: The conventional wisdom is that when interest rates are high, investors prefer bonds and cash. When interest rates are low, they seek yield in the equity market. When rates rise, or rates are anticipated to rise, dividend-paying stocks often take a hit. But we tested whether this relationship between interest rates and dividend payers held over the long term. In periods of rising rates, did dividend-paying stocks suffer, and in periods of falling rates, did they outperform? We found that the relationship was far from straightforward. There are really a lot of factors that are at play. The wider context really matters. Just to sight one example, in the late '90s, the Fed was cutting interest rates in the wake of the financial crisis. But if you remember, in the late '90s, investors did not want dividend payers, they didn't even want earnings.

Wallace: Right. There's a lot of moving parts there.

Lefkovitz: Absolutely.

Wallace: What should investors take away from this study?

Lefkovitz: I think the most important thing is, there are a lot of reasons to invest in dividend-paying stocks. From a yield perspective, from a total return perspective as well, dividend payers really do very well. The dividend commitment instills a lot of discipline on corporate managers and studies have shown that a lot of the long-term total return from equity markets come from dividend payments, reinvested dividends. But you don't want to prioritize income at the expense of total return. You don't want to chase yield into stocks that are really risky and maybe will cut their dividend payments in the future or fall into financial distress.

Wallace: This is really interesting research. Thanks for being here to discuss it.

Lefkovitz: Thanks, Karen.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.

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Eric Jacobson: There's no question that PIMCO Income has been truly impressive. The fund boasts a world class team, an effective, time-tested process, and a stellar record. The strategy's assets have grown at an astonishing rate, though, which partly explains why its Morningstar Analyst Rating is Silver rather than Gold.

Assets in the overall strategy--in other words, assets across the small handful of vehicles PIMCO manages the same way around the globe--dipped a little in May, but have otherwise ballooned over the past couple of years. They stood at more than $207 billion at the end of May, having more than doubled since the beginning of 2017.

That gives us some pause because it will eventually make it more difficult for the fund to benefit as much from the kind of sector and security level bets--particularly among nonagency residential mortgages--that have helped the fund shine so brightly over the past several years. That sector has some truly unique positive traits given how beaten down it was after the financial crisis.

PIMCO has done a really good job thus far at keeping up their allocation to the sector in the fund even as it has gathered so many assets; they comprised roughly 30% of the portfolio at the end of May. But the sector is shrinking because there’s been very little new issuance.

We think investors would be better off if PIMCO were to think about closing the fund, even temporarily at some point, if they begin to find it too difficult to keep the portfolio's nonagency mortgage stake at a level they like. PIMCO disagrees, though, arguing that the fund's massive global opportunity set will continue to give them plenty of choices to keep generating great returns.

The bottom line, though, is that we still think this is a great fund, with great resources, and great managers.

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Andrew Daniels: Gold-rated Artisan International Value and Artisan Global Value have several similarities. Both funds are managed by David Samra and Dan O'Keefe, two-time winners of the Morningstar International Stock Fund Manager of the Year award. Samra and O'Keefe are value investors who emphasize quality firms with financial strength and shareholder-oriented management teams. Consistent with management's long-term mindset, turnover is generally low. Both portfolios are compact, holding 40 to 60 stocks, and it's worth noting they're currently tilted toward financial services and technology stocks.

Despite similarities in management and process, there are also differences to highlight. Not surprisingly, Artisan Global Value has a heavy U.S. stake of approximately 40% as of March 2018, though that’s well-below the MSCI ACWI Index’s 52% exposure. Management has pulled back its U.S. stake since mid-2016 because of heightened valuations. Moreover, International Value is closed to new investors in order to protect current fundholders, yet Global Value remains open. As such, for investors seeking diversified global equity exposure, Artisan Global Value is an excellent and available option.