Dividends Are Back

We are just months removed from one of the worst years for corporate dividends on record. Uncle Sam is expected to take another big bite out of that income in 2011 in the form of sharply higher taxes.

And yet dividend investing has rarely looked better.

This year through mid-June, there were at least 135 dividend increases or initiations among the companies in the Standard & Poor's 500-stock index, up roughly 55% from the first six months of last year.

If the economy continues to gather strength, analysts say, many more companies will likely gain the confidence to boost dividends this year.

So what has changed? Corporate balance sheets, which were squeezed during the recession, are once again brimming with cash. S&P 500 nonfinancial companies had a record $837 billion in cash at the end of the first quarter, up from $665 billion a year earlier, according to S&P.

Of course, there are plenty of headwinds. The tax rate on qualified dividend payments, capped in 2003 at 15%, is set to expire at the end of this year along with some other Bush-era tax cuts. Absent congressional action, the top dividend tax rate will jump to 39.6% next year. It also could end up somewhere in between.

But for investors looking to generate steady income, the alternatives to dividends don't stack up well. With the Federal Reserve keeping its key interest rate at a historic low, the roughly 2% average dividend yield of the S&P 500 looks attractive relative to many bond and cash-like investments. The average taxable money-market fund, for example, offers a paltry seven-day yield of 0.04%, according to iMoneyNet, which tracks the funds. Bonds carry risks of their own, and must be rolled over and reinvested when they mature.

The long-term case for dividend investing, meanwhile, remains sound. Some research suggests that companies tend to boost these payments ahead of significant increases in cash flow. And dividends often provide a cushion when stock returns sag. That can be especially valuable for income-focused investors like those looking to cover regular living expenses during retirement.

Wall Street Journal