Investors are loving dividends these days, no surprise given the desire for steady cash flow in a world of paltry Treasury yields and unsettling market volatility.

Certainly, the case for equity income is compelling. The yield on ten-year Treasury bonds has been hovering at around 2%, while Treasury bills have been yielding practically zilch. And the eventuality of rising interest rates makes bond investing riskier and less appealing.

Conversely, the dividend yield on the S&P 500 was roughly 2.2% in early December. And with corporations sitting on record amounts of cash at a time when the collective S&P 500 payout ratio resides near historic lows, there's ample opportunity for higher payouts down the road. And it doesn't hurt that dividend income remains taxed at favorable rates-at least for now.

The talking heads in the media have been pounding the table on large-cap dividend stocks, and investors have taken note. As of November 30, dividend-paying stocks in the S&P 500 were up an average of 0.85% year to date, while non-dividend payers lost 5.41%. "The dividend payouts have helped [boost returns]," says Howard Silverblatt, Standard & Poor's senior index analyst. "But you're seeing more investors in general going for companies that pay dividends, and they're looking at their coverage ratios to make sure the cash and earnings potential are there."

While it's a stretch to call the current lovefest for equity income a mania, a herd mentality is brewing. In a recent blog on Vanguard's Web site, Joe Davis, the company's chief economist, wrote about a friend who thought it a no-brainer to substitute dividend-paying stocks for bonds in his portfolio since the dividend yield on the stock fund was higher than the yield to maturity in the bond fund. Plus, he'd get an upside kicker when stock prices rebound, while bond prices will likely decline as yields inevitably rise.

In a follow-up interview, Davis said Vanguard is seeing strong inflows into both equity-dividend index funds and actively managed funds with a strong dividend focus. But he's concerned that some income-hungry investors will ditch the fixed income part of their portfolios in favor of equity income.

"It's still equity, so the overall risk characteristics of the model portfolio can dramatically change," Davis says. "Is that a prudent trade-off to make? Our point is that it's not a risk-free transaction. We're trying to remind people to think about performance on a total return perspective."

Re-evaluating Bonds

Eric Dunavant, a certified financial planner in Mandeville, La., says he's had conversations with some of his clients about what it might look like to replace fixed income investments with equity income. He recognizes that some of his clients couldn't emotionally handle an all-equity--or, at least, a more equity-laden--portfolio. But he says it's fair to ask whether it's time to re-examine the role of fixed income in asset allocation models.

Dunavant is concerned that investors have been lulled into a false sense of security that bonds are safe. "Are bonds a safe asset class over the next ten to 15 years in a rising interest-rate environment versus equities?" he asks.

He cites McDonald's Corp., a reliable dividend grower that recently sported a fat yield of about 3.2%, as an example. "Over the next ten years, McDonald's isn't going anywhere, and it'll be paying a nice yield," Dunavant says. "Would you want a McDonald's bond or a McDonald's stock?"

Dunavant says he divides the equity portion of his portfolios into two parts. One portion consists of 25 stocks in a tactically managed portfolio of mainly small caps and mid-caps. The other portion is a 25-stock dividend portfolio strategy devised by BigFoot Investments, which among other things develops portfolio strategies for financial advisors.

One of the portfolios offered by BigFoot, an offshoot of Lee Johnson Capital Management in Fort Worth, Texas, is a 25-stock equity-dividend portfolio that focuses on companies with high dividend yields and a history of annual dividend increases. The firm reasons that investing in consistent dividend-paying companies can boost portfolio performance while reducing risk. BigFoot also posits that dividends provide tangible confirmation that a company's management has confidence in its future earnings growth, and that dividend payers generate higher income over long periods if they're reinvested.

The company uses five dividend-related screens to create its equity-dividend portfolio. "We feel there's greater opportunity in owning dividend-paying stocks than bonds in this environment," says Lee Johnson. He notes that BigFoot screens the equity-dividend portfolio quarterly, but can make changes quickly if events warrant. In late October, BigFoot cashed out of Avon Products after news broke that the company was being investigated by the SEC for possible disclosure violations of its information to financial analysts.

Other Options
John Valentine, president of Valentine Capital Asset Management in San Ramon, Calif., is another advisor who's bullish on dividend-paying stocks. In the past, the company's Income Plus portfolio had been its fixed-income portfolio for clients, and depending on market conditions, the predominant investment vehicles have ranged from convertible bonds to zero-coupon bonds.

Today, though, the portfolio aims to boost cash flow in large part by investing in dividend-paying stocks, as well as collecting premiums generated from selling covered call option contracts on the portfolio's stocks.

"The portfolio has to adjust to the current environment," Valentine says. "I'd put any dividend-paying, covered call writing portfolio against any bond portfolio in the next decade, and it would win hands down."

Valentine says the recent sustained levels of market volatility have juiced covered call premiums to the highest levels he's ever seen, making this strategy particularly profitable because it can add, on average, 0.75% to 2% in cash flow every 60 days when covered calls are written on high-yielding dividend stocks.

For example, he says, in early December a person could buy Chevron's common stock for $103 a share and could write, or sell, a January call option on it with a $105 strike price for $3.15. If things break right, the math goes like this: 3.15 x 6 (six different periods of 60 days within a year, assuming the contracts are rolled over every 60 days) = 18.9. When divided by 103 (the cost basis of the common shares), that results in a possible gain of 18.3% from the covered call, on top of the common share's recent dividend rate of more than 3%.

"That's a 21% return [from the dividend and covered call writing] if you continue to roll those covered calls [every 60 days]," Valentine says.

That is, if the covered call buyer doesn't buy the stock at the strike price. If that happens, the writer of the covered call has to give up the stock and his capital appreciation is capped, but he keeps the premium from selling the covered call. And when investors have to give up the stock, they can get back into that stock or a similar quality stock and sell covered calls on that, too.

"It's a sophisticated strategy and definitely not for every client because not all clients will understand it, but our executive client base understands it," says Valentine, adding that the Income Plus portfolio can range from 10% to 55% of a client's overall portfolio.

Payout Potpourri
The Payden Value Leaders fund recently boasted a yield of roughly 5% by investing in a combination of high-yielding dividend stocks, preferred shares, real estate investment trusts, master limited partnerships and business development corporations.

"Because we're a multi-asset-class firm [the parent company is Payden & Rygel], we look across the entire spectrum of asset classes to find companies that can maintain and grow their dividends," says fund co-manager Jay Wong.

Common stocks are about two-thirds of the fund, but sometimes the preferred shares make more sense to the fund's managers. Such is the case with one of its largest holdings, Public Storage, a publicly traded REIT. The fund invested in the company's preferred shares because of their higher yield. "Sometimes the common shares have greater volatility and less yield than the preferreds," says fund co-manager Frank Lee.

A sometime component of the Value Leaders fund is business development corporations, a niche asset class whose entities act like private-equity funds by making investments in small to midsize companies. Unlike private-equity funds, BDCs are open to retail investors. And like REITs, they must distribute at least 90% of their taxable income to shareholders in the form of dividends. The fund cashed out its recent holdings of Ares Capital Corp. and Apollo Investment Corp., and currently holds no BDCs.

The different strategies employed by the plethora of dividend-focused funds means that investors must do their homework. Steven Rogé, portfolio manager at Rogé & Company Inc. in Bohemia, N.Y., says he's not a fan of dividend-oriented exchange-traded funds because they tend to have a lot of financials and utilities in their portfolios, neither of which he particularly likes. The former, he says, are still dealing with a lot of issues and the latter are highly levered.

Rogé's firm uses mostly mutual funds for its clients' equity exposure, including the Vanguard Dividend Growth fund, which he likes because it has the types of consistent dividend growers he favors, such as Microsoft, Exxon Mobil, Johnson & Johnson, PepsiCo, and Abbott Laboratories.

"Most of these companies are unlevered, so they won't have credit issues like utilities would if the economy hits a rough patch," Rogé says. "They should hold up more nicely."

Passing On Dividend Payers
Kevin Kroskey, president of True Wealth Design, a financial planning firm in Akron, Ohio, says he doesn't use any dividend-focused funds because they're typically value-weighted, large-cap portfolios heavy on the consumer defensive, utility and communication services sectors.

"You're forsaking diversification if you rely on a dividend-paying strategy," Kroskey says. "It's not that I don't like dividend yield. It's just lower on the criteria list after cost, diversification and how the fund does or does not fit into my asset-class level modeling."

Kroskey says he invests for income by focusing on a client's cash-flow needs. For time horizons between five and 12 years, he'll use individual, taxable municipal bonds and match a client's expected liabilities with the interest and principal repayments from these bonds. For less than five years, Kroskey uses cash and shorter-term, high-quality bond funds-typically with a duration of about two or three years. "I'm not concerned about the interest rate risk in the short term on these funds," he says.

About a half-year ago, Ron Carson had a lot of dividend-paying stocks in his clients' portfolios, but his firm has since been rotating out of them, as well as dividend-paying master limited partnerships. Now he thinks it's a crowded trade.

"Everyone plowed into dividend stocks looking for yield, and now what you have are slow-growth companies trading at pretty hefty price-to-earnings multiples that in some cases are 16 to 18 times earnings," says Carson, CEO of Omaha-based Carson Wealth Management Group. "Big dividend payers are good companies and name brands, so they're easy to own. Right now, everyone is doing it, and they should've been doing it two years ago when they had multiples of eight or nine times earnings."

Timing Is Everything
Thomas Huber, the manager of the T. Rowe Price Dividend Growth fund, wrote in a recent report that dividend growth strategies typically don't shine in the early stages of an economic recovery. Instead, they thrive during the later stages of economic cycles such as the current environment, when consistent growth companies with steady income streams find favor.

"This consistency is the hallmark of many dividend growers, and we believe that makes this strategy particularly appealing in today's uncertain markets and a viable strategy over the long term," he said.