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With the 10-year T-note yielding only 3.06%, those investors interested in getting income from their investments are in sort of a tough place. Dividend-paying stocks are a very good place to look for a replacement.

One thing you know for sure is that the coupon payment on a 10-year note is not going to rise. A yield of 3.06% does not offer much of a cushion against inflation.

What is inflation likely to average over the next 10 years? I have no idea, but based on the spread between the regular 10-year note, and the 10-year TIPS, the market is implicitly expecting a rate of about 2.50%, which is pretty much in line with the historical experience (Headline CPI) over the last 20 years of 2.57%.

While core inflation is the thing to keep an eye on when judging if monetary policy is too tight or too easy, it is headline inflation that investors, particularly fixed-income investors, have to be concerned about. After all, the whole point of buying a bond is to defer consumption of a basket of goods and services from today in order to be able to consume a bigger basket of goods and services in the future. Both of those baskets are going to contain food and energy. An expected real return of 0.56% is not a very big payoff for that long a period of delayed gratification.

Inflation Not a Huge Threat

I do not think that inflation is currently a huge threat. I agree with Fed Chair Ben Bernanke that the recent commodity price spike fueled increase in headline CPI is likely to be short-lived. On the other hand, it seems quite plausible to me that we could see much higher inflation a year or two from now, particularly if the economy manages to get back on track and unemployment falls to more normal levels.

I’m not talking about a trip to Zimbabwe, or even a return to the 1970’s, but inflation rising to around 4% would not shock me. Given the huge indebtedness of the consumer sector, and increasingly the government sector, it would not be the worst thing in the world, either -- it could actually be a good thing (although here is a case where one can easily have too much of a good thing).

If that proves to be the case, then your real return on the T-note will be negative. The yield will rise, and the price of the bond will fall. You are simply not being paid very much for taking that risk.

Debt Ceiling to Increase...?

Of course, if we don’t increase the debt ceiling -- and it looks like there is a real possibility that the Government could even be a few days late in making an interest payment -- the rise in T-note yields could happen much sooner than that. I expect that the increase in the debt ceiling will happen, but that it will probably fail at least once before it happens.

That could make the markets very nervous. Not raising it would be the absolute height of fiscal irresponsibility and incompetence in Congress, but before it gets raised there might be a lot of interesting political theater. If you want to directly play a rise in T-note yields, short treasury ETF like TBT are a good call. Most investors though will probably just want to find potential shelter from the storm. A basket of high-yielding stocks is a very good safe harbor.

It is, however, a mistake to only look at the dividend. Buying a stock because it yields 4.0% and seeing the stock fall by 5.0% right after you buy it is not going to make you either happy or wealthy.

How to Find the Best Dividend-Yielding Stocks

You want to find both a good steady income, and some potential for near-term appreciation. Therefore, I looked for stocks that are currently rated either #1 (Strong Buy) or #2 (Buy) based on the Zacks Rank.

It just so happened that all that passed the other requirements were “#2s.” Dividend investing is a long-term strategy, and the Zacks Rank is mostly for shorter-term traders, but even long-term investors should not ignore it entirely. It is still a good timing tool for them.

If you are buying a stock for income, the last thing you want to see is a cut in the dividend. The best defense against that is a low payout ratio. Managements generally will try to avoid dividend cuts, but paying out more than you earn each year is not sustainable. A company needs to retain at least some of its earnings to grow, not just earnings, but the dividend as well. I therefore required that the company pay out no more than 60% of its earnings so there is a very strong cushion against dividend cuts.

One of the nice things about dividends is that they tend to grow, particularly if the company has a history of raising dividends. It is that dividend growth that can protect you from inflation. That is something that a T-note simply will not do for you.

In the screen I required that dividends increase by an average rate of 5% per year over the last five years. In other words, the dividends have increased by more than the rate of inflation over that period. More significantly, the first cut is the hardest. The five percent growth requirement has the added advantage of eliminating any firm that has cut its dividend in recent years

With a dividend plus dividend growth strategy, it is imperative to avoid dividend cuts. I would not expect some of the historic growth rates to be continued. It is highly unlikely that Rogers Communications (RCI - Free Report) is going to generate the sort of earnings growth needed to grow its dividend at over 78% per year over the next five years. Most, however, have dividend growth rates in the mid-teens or lower, and those sorts of growth rates are probably sustainable, at least for a few more years.

Don’t be afraid to look outside the U.S. for income stocks. The dollar has been declining, and I think it will probably continue to do so. That would mean that a dividend paid in Euros or Yen would be translated into even more dollars.

Some of these firms, such as Alliance Resources (ARLP - Free Report) are structured as limited partnerships. That will require a bit more paperwork at tax time (unless, of course, you put them in a tax advantaged portfolio such as a 401-K), but often a big part of those dividends are a return of capital and that portion is generally tax free.

Also, while dividend paying firms are generally larger market-cap firms, that is not always the case, as this screen shows. Yes, there are huge firms on the list like Phillip Morris (PM - Free Report) and Sanofi-Aventis ((SNY - Free Report) , but there are also three sub-$500 million micro-caps as well.

Historically, dividend-paying companies have far outperformed non-dividend paying stocks, and dividends account for about 40% of the total return from owning S&P 500 stocks over the long term. The combination of high dividends plus short-term estimate momentum just could lead to long-term success in the market.

This is not a flashy strategy, but a solidly profitable one. It focuses on both sides of total return -- income plus capital appreciation.

Company Ticker Div. Yield Div Yield 5 Yr Avg Payout Ratio Div. 5-Yr Growth Zacks Rank Market Cap ($ mil)
Bce Inc BCE 4.93% 4.53% 0.67 8.73% 2 $30,062
Alliance Res ARLP 4.89% 6.55% 0.48 13.87% 2 $2,675
Gas Natural Inc EGAS 4.75% 4.84% 0.61 16.36% 2 $89
Alliance Hldgs AHGP 4.68% 5.38% 0.68 23.36% 2 $2,840
Avista Corp AVA 4.50% 3.65% 0.59 16.16% 2 $1,401
Telus Corp TU 4.02% 4.23% 0.61 13.51% 2 $7,769
Natl Bnkshrs Va NKSH 3.83% 3.59% 0.41 5.64% 2 $174
Rogers Comm Clb RCI 3.74% 2.32% 0.47 78.23% 2 $16,717
Philip Morris PM 3.63% 4.38% 0.64 10.17% 2 $126,734
Rpm Intl Inc RPM 3.60% 4.09% 0.6 5.63% 2 $3,046
Sanofi-Aventis SNY 3.53% 2.96% 0.25 7.06% 2 $101,419
Tompkins Fin Cp TMP 3.53% 3.09% 0.43 5.56% 2 $421