Dip into high-dividend payers

By Carolyn Bigda, staff writer

Dividend-paying stocks have traditionally been the plain Janes of the market -- dependable but nothing to get excited about. Lately, though, they've gained a new allure, with many blue chips yielding more than top-rated corporate bonds, providing investors with the opportunity to earn payouts up to 4% or more.

Adding to their appeal: Dividend stocks typically have a better shot at capital gains than bonds and enjoy more favorable tax treatment, at least for now. (Dividends today are taxed at a top 15% rate, vs. 35% for bond interest; that limit is set to expire in January but Congress is debating a new cap of 20%.)

What's behind the fat payouts? They are largely a function of falling stock values. As prices have declined over the past decade (and fallen 5.9% so far this year), many high-quality companies have continued to pay, even increase, their dividend.

As a result, their yields -- calculated by dividing the annual cash dividend that a company pays out per share by its stock price -- have been rising. Lately many of these same companies have built up record amounts of cash reserves, providing even more of a cushion with which to pay and raise dividends.

But if the economy worsens, corporate profits might come under pressure again, squeezing dividends, warns Lewis Altfest, a wealth manager in New York City.

Just remember 2009, when a record number of firms cut or suspended their dividend. Or earlier this year, when BP halted its payout after the gulf oil spill. To make sure your 4% target is safe, follow these steps:

1. Aim for the sweet spot. Focus on high-quality companies with a dividend yield between 4% and 6%. That's a lot higher than the 2% average yield on the S&P 500 but not so lofty that the company may be hard-pressed to keep up payments.

One way to spot a sustainable dividend: Look for companies that use no more than 50% of their earnings to pay shareholders (known as the payout ratio). That leaves ample funds to plow back into the business.

Also key: dividend payments that will grow over time. Ideally you want to zero in on companies that have in creased payouts for five straight years or longer. "They give your portfolio the juice it needs to keep up with inflation," says Cliff Remily, co-manager of Thornburg Investment Income Builder.

2. Build on a strong core. You can assemble a diversified portfolio that meets these criteria with a half-dozen or so well-chosen individual stocks and funds.

For your foundation, put half the money you're allocating to dividend payers in the SPDR S&P Dividend (SDY), an exchange-traded fund that tracks the 50 highest-yielding stocks in the S&P 1500 index of large, medium, and small companies that have paid a dividend for 25 consecutive years or more. Recent yield: 3.6%. Among its holdings: household products maker Kimberly-Clark (KMB), yielding 4.1%, and components manufacturer Leggett & Platt (LEG), yielding 5.6%.

Then, to get to a 4% yield overall, put the rest of the money in a handful of stocks that together will pay an average of 5%. Start with picks from the traditionally high-yielding telecommunications and utilities sectors.

David Katz, chief investment officer of Matrix Asset Advisors in New York City, likes wireless giant AT&T (T), which has more than doubled its cash reserves since 2006 and was recently yielding 6.2%.

MONEY columnist Pat Dorsey, director of equity research at Morningstar, is keen on Exelon (EXC), the country's largest nuclear plant operator, which has raised its dividend 5.6% annually over the past five years and now yields about 5.2%.

Then spread the rest among different industries and regions. Laton Spahr, co-manager of Columbia Dividend Opportunity, likes drug giant Merck (MRK), which yields 4.3% and uses about 40% of its cash to pay the dividend, and Intel (INTC), yielding 3.6%, which has boosted its dividend 17% annually over the past five years. Another smart bet: European telecom Vodafone (VOD), which has a 48% payout ratio and currently yields 7.%.

3. Use funds as an alternate approach. Not keen on making individual picks? You can also put together a well-diversified, high-yielding portfolio with a handful of mutual funds and ETFs. Once again, use the SPDR S&P Dividend ETF as a core holding, putting about 25% of the money you're allocating to dividend payers in it.

Add even more yield by putting another quarter each into the market's two highest-paying sectors with the Utilities Select Sector SPDR (XLU), yielding 4.1%, and iShares S&P Global Telecommunications (IXP), doling out 4.4%, suggests Scott Burns, director of ETF research at Morningstar.

Then, for international diversification, split the remainder between Vanguard European (VGK), yielding 4.2%, and Matthews Asia Dividend (MAPIX), with a payout of 3.3%. Average yield on the portfolio of five funds: about 4%.

Or if you'd prefer to leave the yield-hunting entirely to a portfolio manager, look at Columbia Dividend Opportunity (INUTX). The fund aims to pay out 1½ times the yield of the S&P 500 and counts AT&T, Intel, and Merck among its biggest holdings. Recent yield: 4%.

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