NEW YORK (Money Magazine) - Dividends are fashionable again. After years of ignoring yields and focusing almost entirely on growth potential, investors are taking a fresh look at the idea of buying stocks for income.

Companies have heard this message loud and clear. In July, Citigroup raised its payout a stunning 75 percent -- from 20 cents to 35 cents a quarter. And since May, more than 50 companies in the S&P 500 have increased their dividends by an average of 28 percent.

Income Guide 2003 •  Stocks and Funds that pay •  The case for yield stocks •  Rethinking Income •  Retirement: Coping with low yields

At first glance, this trend may seem unsurprising. Investors typically seek refuge in conservative stocks during and immediately after a slump, just as they favor growth stocks in a bull market.

But what's going on today is more radical. An exceptional set of economic factors -- new tax breaks, very low inflation and the end of a massive interest-rate decline -- are encouraging investors to reconsider their approach to income.

The bright line between principal and income has grown blurrier. And today, when rock-bottom interest rates have nowhere to go but up -- a move that would knock down bond prices -- income investors need to pay increased attention to principal preservation.

Companies that pay rich dividends and also offer long-term share-price gains may actually be safer than government bonds. And they may also provide total returns that rival those of much riskier growth stocks.

In short, high-yield stocks are more attractive than they've been for two decades.

This story explains the economic changes that have put dividends in the spotlight and suggests a more dynamic approach to income investing, citing seven solid stocks yielding up to 4.4 percent.

Strange as it may seem, dividend stocks went into eclipse mainly because of the massive interest-rate decline that began two years after President Jimmy Carter appointed Paul Volcker chairman of the Federal Reserve with a mandate to crush inflation.

Yields on 10-year Treasury bonds peaked at 15.8 percent in 1981. Since then, Volcker and his successor, Alan Greenspan, have steadily pushed rates down. The yield on the 10-year T-bond hit a 40-year low of 3.2 percent earlier this year.

You might think that falling interest rates would make high-yield stocks look more attractive and boost share prices -- and they did. But they helped Treasury bonds and growth stocks even more, and income stocks suffered by comparison.

Between 1984 and 1995, long-term Treasuries earned compound annual total returns averaging more than 13 percent. And they have gained more than 10 percent a year since 2000.

From 1995 through 2000, growth stocks were the biggest beneficiary of falling rates.

How do lower rates boost growth stocks? Earnings gains projected for future years appear more attractive when rates are low. And lower bond yields encourage investors to move money into equities.

But neither top-quality bonds nor growth stocks seem likely to be the big winners as the next economic recovery unfolds. Over the past 75 years, dividends have accounted for one third of the total return on stocks.

Moreover, studies have found that companies with moderate earnings growth -- 12 to 16 percent a year -- provide higher average long-term returns than the most aggressive stocks do.

It's hard to sustain earnings gains of more than 16 percent a year. The fastest-growing businesses disappoint sooner or later -- and then their prices tumble.

With interest rates at record lows, dividend-paying stocks stack up well against most fixed-income alternatives simply on the basis of how much money they put in your pocket.

Money funds and CDs may be fine places to stash cash, but as they pay only 1 percent or so, they can't keep up with taxes and inflation.

Income taxes reduce those yields to about 0.7 percent. And with inflation running above 2 percent, the net result is negative.

Longer-term bonds offer fatter yields, but as the chart above shows, dividend stocks are now quite competitive. Thanks to the new tax law, dividends are taxed at a top rate of 15 percent vs. 35 percent for interest income. So a stock paying 3.5 percent will yield more after taxes than a 4.5 percent bond.

And while bonds are often thought of as safer than stocks, that may not be true today. Bonds lose value when interest rates rise -- and forecasters project that today's low interest rates could rise two percentage points over the next five years.

Dividend stocks, in contrast, are a little less vulnerable to rising rates; for one thing, companies usually raise their dividends over time, while the payout on a bond never changes.

That leads to another crucial advantage of dividend stocks. Even at today's extremely low inflation rate, the purchasing power of the principal in a fixed-income investment is cut in half over 30 years. And should inflation revive to top 5 percent, that half-life could shorten to 15 years or less.

You can offset the erosion caused by inflation if you reinvest some of the interest you receive -- but you'll have to pay taxes on that money first. High-yield stocks, by contrast, generally don't need any help keeping up with inflation -- they typically enjoy at least 3 to 5 percent growth.

Best of all, that growth is financed by earnings that the company retains, so you don't incur unnecessary taxes.

When you take into account the need to top up your principal, it's clear that inflation can take a heavy toll on your real yield. Imagine that inflation is 9 percent -- as it was in 1981 -- and that you own bonds with a 13.5 percent yield.

After taxes, you'd be earning less than 9 percent; subtract inflation and your return is zilch.

By contrast, if inflation is today's 2.4 percent and yields are 4.5 percent, you'd have 3 percent after taxes and 0.6 percent after inflation.

The best deal, though, comes from stocks benefiting from reduced taxes on dividends. A stock with a 3 percent yield gives you 2.5 percent after taxes -- and inflation can be offset by share-price growth.

The problem of principal erosion by inflation points to a crucial misunderstanding. Most investors think a bright line can be drawn between principal and the income it generates.

This notion goes back centuries to a time when most wealth was in the form of land, which retained its value indefinitely. The income consisted of the crops or the rent that the land produced. This distinction between principal and interest continued to make sense through the second half of the 19th century, when there was no income tax and little inflation.

But throw inflation and taxes into the mix, and the distinction breaks down. Moreover, the yields offered by bonds get overstated, while those of stocks get understated.

With bonds, you have to reinvest some of your interest to make up for your loss of purchasing power. With stocks that grow faster than inflation, by contrast, you can afford to spend all your dividends and a little bit of your capital gains as well.

The true goals of an income investor, therefore, have nothing to do with obtaining the highest nominal yield. Your real objectives are 1) making sure the market value of your portfolio remains relatively stable, 2) earning returns that are fairly predictable and 3) having the option of regular cash payouts.

And that's where high-yield stocks really shine. A portfolio containing a dozen blue chips with projected earnings growth of 3 to 5 percent a year should stay ahead of inflation.

The stocks' dividends should be stable and predictable, and shareholders can either spend their payouts or reinvest them. Best of all, taxes will be held to a minimum.

Once you recognize that the distinction between principal and interest is somewhat artificial, there's the possibility of managing a stock portfolio to maximize total return and then spending some of your capital gains as well as income.

Aggressive growth stocks are too volatile for this plan. But you should be able to take 5 percent a year from a well-balanced portfolio of stocks with a 3 percent average yield and 6 percent average earnings growth and still keep up with inflation of as much as 4 percent.

And what about the conventional wisdom that you should divide your portfolio between stocks and bonds and adjust your mix (favoring bonds) as you get older?

In fact, the portfolio mix that's best for you depends chiefly on how much money you have.

Conservative octogenarians can afford to keep all their money in stocks, as long as they're rich enough. If you need $100,000 a year and you have $3 million, you can put it all in high-quality stocks paying an average of 3.4 percent and just hold them.

As long as dividends are raised at least as fast as inflation, your purchasing power won't erode.

Most people don't have that kind of money and are well advised to include bonds or preferred shares in their portfolios. But it still makes sense to put more than half your money into conservative equities.

Shares with yields above 3.5 percent and high payout ratios are worthwhile for current income. Those with yields of at least 2 percent, lower payout ratios and higher growth offer greater long-term returns.

Click here for seven stocks that cover the spectrum.