Is Your Portfolio Paying Enough Dividends?

OCEAN CITY – Most of the news about dividend-paying stocks during the first
half of the year focused on the oil spill in the Gulf of Mexico. When BP
suspended its dividend to brace itself for the costs and responsibility
associated with one of the worst environmental disasters in U.S. history,
investors were reminded again of the importance of maintaining a diversified
investment strategy.

Behind the headlines, though, a more upbeat dividend-paying story has
quietly been unfolding — this group of stocks as a whole has emerged
as something of a hedge against recent market volatility.

"Dividend-payers are typically high-quality companies with robust cash
flows and solid balance sheets," says Ash Rajan, Head of Investment
Policy, Investment Management and Guidance for Merrill Lynch. And at a time
when yields on short-term bonds have sunk below 1%, dividend stocks can
potentially provide a robust and relatively liquid source of income. "All
these factors just make them very attractive," he says.

There’s a common perception that dividend-paying stocks are best suited to
conservative investors or those in or nearing retirement. They can use some of
the income they might otherwise deploy for fueling growth to reward
shareholders, companies that pay dividends "haven’t gone up as much in the
good times," observes Howard Silverblatt, senior analyst at Standard &
Poor’s, "and, in general, they historically haven’t gone down as much in the
bad times. The dividend can often act as a kind of anchor, holding the stock
relatively steady."

But it would be a mistake to equate these stocks’ lower rates of
appreciation with lower returns. That’s because the most sought-after
dividend-paying stocks have the potential to pay investors in two ways: through
capital appreciation and yield.

To be sure, the most significant headwind for dividend-paying stocks came
during the recent economic downturn. Last year, in an effort to shore up their
balance sheets, more companies cut their dividends than at any other time in
history. "It was an unusually bad time — reducing a dividend by
a significant margin is quite a rare event," says Subramanian. Still, even
that tough stretch could pave the way for healthier dividends in the quarters
ahead. "Corporate cash balances are higher than ever," she explains.
"In an improving economy, we expect more companies may use the cash
they’ve stockpiled to increase dividends to court yield-seeking investors."

In fact, if there is a cloud hanging over dividend-paying stocks, it may
have less to do with market dynamics or the mounting disaster in the Gulf than
with the fiscal storm gathering in Washington, D.C. In 2003, President George
W. Bush lowered the tax on qualified dividends (dividends on shares held by the
shareholder for at least 60 days before and after the dividend issue date, or
90 days for preferred stock) to 15%, the same rate as the capital gains tax.
Now that those cuts are scheduled to expire at the end of 2010, qualified
dividends are slated to be taxed again at the same rate as ordinary dividends
and all other forms of ordinary income. With ordinary income rates for top
earners set to rise to 39.6% (and to 44% when a new health care surcharge takes
effect in 2013), that would mean a near tripling of the dividend tax rate in
the next three years.

Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)