The Great Crash of '08-'09 caused investors to give fixed income a lot of love. Perhaps too much love, as the fear trade drove people into the arms of U.S. fixed-income securities in a rally that boosted prices, decimated yields-which move in the opposite direction of price-and raised fears among many analysts of a bond bubble waiting to burst.

In turn, that helped raise the profile of dividend-paying stocks for retirees, soon-to-be-retirees and other income-seeking investors wanting better than the puny returns of U.S. fixed income. Riskier than bonds but generally less volatile than so-called growth stocks, dividend-paying equities are a source of steady income and can help boost returns in bear markets. Moreover, reinvested dividends can dramatically goose long-term returns.

And with the December agreement to extend the Bush tax cuts through 2012, it appears dividends will keep their tax-friendly rate of 15% rather than a return to higher marginal income tax rates.

Even though the bond rally fizzled and fixed-income yields gained during the latter months of 2010 as the Federal Reserve's second round of quantitative easing caused investors to sell bonds and the tax-cut extension raised expectations for economic growth and subsequent higher interest rates, it's always smart to think about dividend-paying strategies beyond fixed income.

Unleash The Power
"Many investors have the misconception that dividends are for the rocking chair set. It's really the opposite," says Don Schreiber, CEO and president of WBI Investments, a money management firm in Little Silver, N.J. "They're fundamentally a better way to increase the odds of success."

Investors like growth stocks because that's where the capital appreciation action is, and many tend to view dividend-paying stocks as a fuddy-duddy relic from a bygone era. For Schreiber, the debate over growth and dividend-paying stocks is easy to call. Growth stocks have a place, particularly in the first couple of years or so coming out of a recession, he says. But he says history shows that dividend-paying stocks trump growth stocks whose returns are based solely on capital appreciation.

"You unleash the power of compounding and dollar cost averaging [with reinvested dividends], which can dramatically increase returns over long time periods," Schreiber says.

He cites Standard & Poor's research that shows $10,000 invested in the S&P 500 in 1930 would've grown to $490,000 by year-end 2009. When reinvested and compounded dividends are included, that figure zoomed to $12.5 million.

Schreiber says dividend-paying stocks are the core portfolio tool his company uses to build the portfolios for its clients and for advisors who use WBI's funds for their clients. He says every individual security they buy must exceed a dividend yield amount. That amount varies depending on the portfolio, as well as the yield on the S&P 500, which is the firm's benchmark index. 

As of early December, the index sported a dividend yield of slightly less than 2%. Meanwhile, the yield on WBI's conservative-balanced portfolio was roughly 3.5%, the firm's dividend income portfolio yielded 3.25% and its dividend-growth portfolio had about a 2.5% yield.

Regaining Importance
Dividends lost importance in recent years as investors emphasized growth stocks and gave more credit to companies that bought back stock than those that raised dividends. But the outlook might be changing.

John Buckingham, chief investment officer at Al Frank Asset Management in Laguna Beach, Calif., says renewed interest in dividend-paying stocks is a back-to-the-future scenario that recognizes the role dividends can play in overall total returns. Plus, dividends are tangible. "You can't fudge a dividend," he says.

Al Frank is a value shop that invests across all market cap segments, but Buckingham says he's been adding more large-cap companies of late because of their poor performance in recent years. "I think the underperformance of large-cap and dividend-paying blue chips will ultimately reverse," he says, which would heap capital appreciation upon current dividend payouts to boost total returns. "As investors gain greater confidence in equity markets, the first place they'll want to go is bluer chip large-cap stocks."

Cliff Remily, co-manager of the Thornburg Investment Income Builder fund, says his fund generates income from equities, fixed income and a dash of convertible securities. The fund's allocation to fixed income was 44% during the downturn's trough. "We did it opportunistically, not as a defensive move," he says. Similarly, new opportunities in dividend-paying stocks have helped trim fixed-income holdings to 29% at the end of November. "Dividend-paying equities is a pretty safe place because valuations are cheap," he says.

Remily says the fund's collective equity holdings recently sported an average-weighted dividend yield of 6.2%. Rather than scouting for high yielders, he says the fund's managers screen for companies with growing businesses, consistent dividend growth and steady cash flows to support that growth. One of the companies Remily likes is AT&T and its 6% yield. "It's a stable, ballast-type holding in a portfolio," he says.

Overseas, the fund sees opportunities in European utilities that recently yielded about 7%. One his favorite companies is Telstra, an Australian telecom giant that traded at nine times earnings and a shade less than five times enterprise value to EBITDA, a key telecom valuation metric. Its recent yield was about 10%.

Investors have punished Telstra's stock-and driven up the yield-after it lost market share in its wireless business and responded by revamping and boosting its advertising and marketing. Remily believes this is a short-term hiccup that creates a buying opportunity. He also believes some investors are wary of the 10% yield.

"People are scared of high yields after what happened to financials in 2008 and 2009, and the knee-jerk reaction is they don't want to buy a 10% yield because it'll get slashed," Remily says. "That's not the case here because they're a big cash generator so they won't have problems paying their dividend."

Alternative Ways To Play
Perry Piazza, director of investment strategy at Contango Capital Advisors Inc. in San Francisco, says his company taps into three sources of income for its client portfolios-traditional fixed income, traditional equity income and hybrids that can include convertible bonds, preferred shares, real estate investment trusts, closed-end funds, and master limited partnerships. They also employ foreign and emerging-market bond funds, and well as loan funds.

Piazza's take is that there's more to income-generating strategies than dividend-paying stocks or Treasury or municipal bonds, and the strategies might change depending on market conditions.

For clients who are retired or are primarily focused on income, Piazza says Contango typically builds a core portfolio of laddered bonds in-house. For clients willing to broaden their income strategies, Contango adds on satellite income-generating strategies from a mix of the above-mentioned hybrid options, dividend-paying equities and other vehicles. And they invest in them through mutual funds and exchange-traded funds that throw off dividends.

"We use funds because these strategies carry more risk and we want to get out of them relatively quick if the need arises," Piazza says. "Satellite income strategies can change based on our perception of value."

In 2009, Contango's satellite portfolios included convertible bonds and MLPs, but it shifted out of those vehicles after they rallied. Since then, Piazza says, Contango's satellite strategy has been more conservative. At year-end 2010, they employed a dividend-focused ETF, emerging market local currency bonds and leveraged loans. "We still want a little bit of credit exposure, and we don't think there will be another credit crisis to drive up the spreads below investment-grade companies," he says.

Piazza says they try not to change things too much because they don't want to generate a lot of capital gains, but they do want to take advantage of relative value in the market. "It's an art, not a pure science," he notes.

Among the funds Contango uses in its satellite income-generating strategies are the Pimco Developing Local and Global Bond funds for foreign and emerging market bond exposure; the Eaton Vance Floating Rate fund for loan funds; the Fidelity Capital and Income fund for high-yield investments; and Kayne Anderson for MLPs.

Contango also uses either the Vanguard or iShares dividend-focused ETFs. "There are different types of ETFs for dividends-some are about dividend growth, others are just high dividends," Piazza says.

At the Goldman Sachs Equity Dividend and Premium Fund, the portfolio is at least 80% invested in dividend-paying large-cap U.S. stocks and foreign stocks. In addition, lead manager Don Mulvihill and his team employs a buy-write strategy that sells index call options on dividend-yielding holdings in the S&P 500 to generate an additional cash flow hedge against downside risk by collecting a premium on the option. 

In flat or falling markets, income generated by the premiums can offset so-so or worse performance in the underlying portfolio. Conversely, the strategy could underperform in a rising market because if the price of the S&P 500 exceeds the call option strike price, the fund has to sell the security at the preset amount and pay the difference to settle the option, and thus risks leaving money on the table.

Mulvihill says the idea isn't to beat the market but to provide tax-advantaged cash flows for the fund's target audience of people at or near retirement and expecting to live off of their wealth. Distributions generally consist of qualified dividends or long-term capital gains. "We think that giving up potential upside in exchange for cash payments fits well with their situation," he says.

Mulvihill notes the fund's goal is to get a 4% option premium per year, on top of the fund's dividend rate, which was recently 1.6%. He says they write calls on a quarterly basis. According to the fund's marketing literature, the fund will sell call options totaling between 25% and 75% of the value of the portfolio.

In 2008, the fund lost 31.6% versus a 36.9% loss for the S&P 500. In 2009, the fund gained 23.5% versus 26.5% for the index. Mulvihill says that since its inception in 2005, the fund's annualized gain of 2.2% has topped the 1.5% return on the S&P 500. "That's consistent with what we've said--we tend to be ahead in weaker markets and behind in stronger markets," he says.

More Dividends To Come
Howard Silverblatt, senior index analyst at Standard & Poor's, says dividend-paying stocks were on pace for a solid year-as of early December, dividend payers in the S&P 500 were up 14.8% versus 12.9% for non-dividend payers, and 236 companies had increased their dividends versus just four companies that decreased them. And he believes strong corporate cash flows will lead to higher payout ratios needed to sustain dividends.

In addition, dividends could get a huge boost if the Fed follows through with plans to let banks increase their dividend payments. "The problem is, we're probably not getting back to where it was in 2008 until sometime in 2013," Silverblatt says. He notes that Citigroup, the former dividend king, used to pay $2.16 a share and one year funneled nearly $11 billion back to investors through dividends. Nowadays, AT&T is the biggest dividend payer.

At year-end 2007, financials comprised 29% of the dividends in the S&P 500. Now, they account for just 9%. The tech sector--often thought of as a growth sector--comes in higher at 9.4%. These days, the largest dividend-paying sector on the index is consumer staples, at 17%.

The joke is that banks want the Fed to say they can increase dividends, but they want limits on them so they can say 'We raised them the best we can,'" Silverblatt says.