Dividend Funds Can Lessen Risk to Income

WHEN THE STOCK MARKET looks scary, companies that pay dividends are supposed to be safe havens. This time around things are trickier, since the bulk of trouble is coming from the traditionally high-yielding financial sector.

In the second quarter, nearly 100 companies decreased their dividends, marking the worst quarterly showing in 18 years, according to Standard & Poor's. This is out of 7,000 public companies that report dividend data to S&P. Nearly 200 have cut dividends through the second half of this year. That's almost twice as many that did so in all of last year.

The carnage is largely coming from financial firms, whose earnings are still smarting from troubles in the housing and mortgage markets. Fifth Third Bancorp (FITB) cut its annual dividend by 66% in June, calling its decision "difficult" but saying that it needs to retain more earnings and shore up capital. KeyCorp (KEY) also cut its annual dividend in June, by 50%, after increasing it for 43 straight years, citing "economic realities."

Political uncertainty could also add to the damper; the next president could raise taxes on dividends, from the current 15% rate, which expires after 2010, back to individuals' marginal tax rates. The top marginal rate is now 35% but slated to rise to 39.6% after 2010.

This isn't the happiest news for investors, especially those who rely on dividend income. "Cutting dividends is one of the last things companies do, because they're not only sending a signal to the market that they're having cash-flow problems but they're also sending that signal to their competitors," says S&P analyst Howard Silverblatt. "This is a bad sign."

But this doesn't mean you should necessarily flee stocks for bonds. Dividend growth has historically kept pace, or outpaced, inflation. So over the long run a stock portfolio focused on dividend income can provide as much or more income than a fixed-income bond portfolio. In addition, "Since 1926, close to 50% of total returns in the stock market has come from dividends," says Jason Trennert, chief investment strategist at Strategas Research Partners.

A wise bet, says Trennert, is to stick with companies that have a long history of raising their dividends, such as those on the S&P's list of "Dividend Aristocrats," which have raised dividends for 25 straight years. An exchange-traded fund, the SPDR S&P Dividend (SDY), tracks S&P's High Yield Dividend Aristocrats index.

In addition, much of the dollar damage to dividends may be done and/or largely confined to financials and, to a lesser degree, consumer discretionary stocks. And while the second quarter was bad, several companies still raised their dividends a good amount in June, including Caterpillar (CAT), CSX (CSX), Medtronic (MDT), Monsanto (MON) and Target (TGT).

Another tactic is to get into a mutual fund that ferrets out such companies. At Dividend Growth Trust Rising Dividend (ICRDX), fund manager Tom Cameron invests in companies that have raised their dividend a minimum of 10% a year for the last 10 years. He especially favors companies increasing dividends at rates faster than their historical averages, such as McDonald's (MCD) and International Business Machines (IBM). "We feel very confident these companies wouldn't have such large increases if they didn't see good business ahead," Cameron says. The fund has sold all of its bank stocks except Bank of America (BAC), and "too bad we didn't sell that," Cameron says.

Another option is mutual funds that focus on companies with large dividend yields. Chris Davis, a fund analyst at Morningstar, says these funds tend to be less volatile over time and "make for good conservative anchors for a portfolio." He recommends T. Rowe Price Equity Income (PRFDX), which has performed well during downturns thanks to good stock-picking. He also likes Vanguard Equity Income (VEIPX), which has a solid long-term record and a very low expense ratio — key for investors trying to maximize income.

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