Tax-Free Bond Exchange Traded Funds: The Ultimate Capture-the-Dividend Play

There is one event and one event only that investors know will happen and for how much on Wall Street; and that is the payment of a dividend. The dividend payment, amount and date are announced well in advance. For this reason, investors should look to develop a strategy to capitalize on this known event. “Capture-the-dividend,” where the investor buys a security solely for the dividend payment, is one way to profit. Focusing on the dividend income from a tax free exchange traded fund offers a number of lucrative advantages for a trader.

Studies have shown that the dividend income now provides more than 40 percent of the total return of a stock. Over the last decade, with the market basically flat, that means that the dividends paid have provided 100 percent of the return. Actually, this would be higher as it means that the capital returns were negative, so the dividend income brought it back to zero.

For a trader, that means there is no reason to own a stock more than those four days a year as more than forty percent, or 100 percent over the last decade, of the total return comes when it goes “ex dividend.” For the rest of the year, it is just “dead money.” Over the past decade for the average stock, owning it other than the four days it went ex dividend would have eaten into your total returns (call it “zombie money” then). A capture-the-dividend trade will allow for the income on just the four days each year a stock goes ex dividend to be acquired.

A capture-the-dividend strategy focuses on buying a stock shortly before it goes ex-dividend, thus receiving the dividend payment. If the ex-dividend date is December 15, the stock must be purchased by December 14th in order to receive the dividend. As the price of the stock will decline for the amount of the dividend paid, it is not sold until the value of the share is recovered. If the stock closed on December 14th at $50.00 and is to pay a $1.00 dividend, it will open on December 15th at $49.00 a share so long as no other developments alter the price.

In a bull market, this works well as the price will continue to rise. In a bear market, this can be treacherous. While “capture-the-dividend’ is a strategy most associated with stocks, utilizing it for the dividend payments of exchanged traded funds for bonds offers a number of advantages, including better performance in a bear market.

In a bear market is when bonds do well. As a general rule, bonds will rise when stocks fall in value for a variety of factors. These include an overall “flight to safety,” the impact of interest rates, more secure income streams and a superior creditor position. Thus, bond exchange traded funds can be expected to rise when stocks fall. This allows for a capture-the-dividend strategy to work profitably for tax free bond exchange traded funds in a bear market. In the present bull market since March 2009, bond exchange traded funds have moved with the rest of the market, making this strategy profitable for declining or surging conditions. With a focus on receiving the dividend income, not an increase in the share price beyond that paid for the stock, there are no concerns about not benefitting from rising values in a bull market.

Buying bond exchange traded funds that are tax free is another huge plus for a capture-the-dividend trade. Taxes on dividends can run as high as 35% in the United States. State taxes will increase the tax burden, cutting into the gains (even states that have no income taxes such as New Hampshire tax dividend income). Dividend payments from tax free bond exchange traded funds are, just that, tax free. With no taxes and low or now trading costs offered by any number of brokerages, transaction costs can easily be zero for a tax free bond exchange traded fund.

Another advantage of bond exchange traded funds is that a capture-the-dividend works best for a security with low volatility, or Beta. This is a major advantage of an exchange traded fund. The stock of an individual company can be too easily distorted by a montage of events. Surprisingly, many blue chip corporations can have very high betas: as an example, Caterpillar, a member of the Dow Jones Industrial Average, has a beta of 1.71. Bank of America, another Dow stock, has a beta of 2.21. Both of these stocks are much more volatile than the market as a whole, which is represented by a beta of 1.

A bond exchange traded fund represents the securities of a number of issuers. As a result, its holdings are diffused among the debt from a variety of entities. This prevents the exchange traded fund from fluctuating from events that would mutate the stock price for an individual company.

A capture-the-dividend strategy can be very lucrative. If tax free bond exchange traded funds were paying four percent in quarterly dividends and you traded just 20 times a year to capture the dividend from five tax free bond exchange traded funds, that is a 20 percent return. It would be difficult to find a comparable return, before or after taxes. In addition, no rise in the share price is needed, just a return to what it was the day before the stock went ex-dividend. An old adage on Wall Street advises that the ultimate trading day ends with all positions closed. A capture-the-dividend strategy comes very close. The more you trade than the 20 days cited, obviously, the more that will be earned.

When a company pays a dividend, the board of directors has a fiduciary duty to ensure that the shareholders are not adversely affected. It does a shareholder little good to receive a dividend if the company is weakened, which will eventually result in the stock price plunging by a greater amount. Since the price of the stock will fall by the amount of the dividend paid the day after it goes ex-dividend, declaring a dividend is an imprimatur from the board of directors of that company that they fully expect the stock price to increase more than the amount of the dividend. As a result, a capture-the-dividend strategy should be considered viable, under normal circumstances. Capturing-the-dividend paid by a tax free bond exchange traded fund offers a number of advantages over that of a dividend from a stock for the investor in terms of lower volatility, no taxes and superior performance under bear market conditions.

By Jonathan Yates