If income is your investment objective, the deck is stacked against you, as interest rates remain velcroed to record lows. But there are attractive dividend stocks out there, provided you can commit for the long run.

Investors seeking current income, who traditionally rely on tax-free municipal bonds or quality corporate bonds, have been forced to take on more risk over the past two decades. Bond yields had sunk even before the bursting of the real estate bubble in 2008, which led to the Federal Reserve pushing the benchmark federal funds rate to its current range of zero to 0.25%.

Low bond yields made preferred stocks, which feature a fixed dividend rate, much more attractive. But high-yielding preferred stocks have also become difficult to come by, as companies have called (or bought back) issues with higher yields, taking advantage of low interest rates and a high level of liquidity to lower their cost of capital.

Another painful trend for investors looking to buy newly issued preferred stocks “off the shelf” from their brokers, thus avoiding commissions, is that many have par values of $100,000. Those and other new preferred issues with lower par values are quickly snapped up by institutional investors.

A major worry for many yield-hungry investors is that when the Federal Reserve begins raising the federal funds rate, market prices for any yield-producing investment can come under pressure. When interest rates rise, the value of an existing bond or preferred stock must adjust itself lower so it has the same yield as a similarly rated new security.

So if you are looking for income, you had better be ready for a long-term commitment. Some investors have been willing to take on more risk by buying dividend stocks. Real estate investment trusts have been popular and lucrative in recent years, with interest rates so low for so long. Business-development companies are another attractive alternative, provided you can ride out high volatility if, and when, another recession emerges. BDCs tend to feature very high dividend yields.

The importance of rising dividends

Purchasing common stocks with high dividend yields may be your easiest way to “buy income” in this market, and if you make the right picks and stick with them through the inevitable short-term fluctuations, you may find yourself outperforming the overall market on a total-return basis.

One example of this is the S&P 500 Dividend Aristocrats, which is a list of over 50 stocks maintained by S&P Dow Jones Indices. The Aristocrats have all raised their dividends annually for at least the past 25 years, and the group has also greatly outperformed the S&P 500 Index SPX, -2.46% over long periods, through June 12:

In the past 10 years, the total return for the S&P 500 Dividend Aristocrats has been 178%, compared with 117% for the S&P 500 Index. FactSet

Here’s how the Dividend Aristocrats and the S&P 500 compare, on a total return basis, with dividends reinvested:

Total return - 3 years Total return - 5 years Total return - 10 years S&P 500 Dividend Aristocrats 69% 127% 178% S&P 500 Index 69% 113% 117% Source: FactSet

As you can see, the longer the period of comparison, the better the relative performance of the Dividend Aristocrats. There are ETFs that track the Dividend Aristocrats. One example is the ProShares S&P 500 Dividend Aristocrats ETF NOBL, -2.63% .

But the Dividend Aristocrats as a group are really a long-term growth, rather than income, play, because many of the stocks in the group feature relatively low dividend yields. The determining factor in their inclusion in the list is the consistency of dividend increases.

A revealing study

So how will we pick higher-yielding dividend stocks? One interesting approach is to screen large-cap stocks for high dividend yields, and then screen them again for quality. Research Affiliates recently published a research report called “The Market for Lemons: A Lesson for Dividend Investors,” which I urge you to read.

The report, written by Chris Brightman, Vitali Kalesnik and Engin Kose, is based on a study of large-cap U.S. stocks using 50 years of data.

The idea of the study is to begin with the largest 1,000 publicly traded U.S. companies, by market value, and compare this group’s performance over very long periods with two other groups: the 200 with the highest dividend yields, and smaller groups of 100 high-yield, high-profitability companies and 100 high-yield, low-profitability companies, by average return on assets (ROA).

The data were adjusted by industry, since measures of profitability can differ greatly, and because new companies were formed and others merged out of existence or were delisted, etc.

Here’s a simplified version of the researchers’ comparison of performance for these three groups from 1964 through 2014:

Group Average total return Average volatility Realized dividend yield 5-year dividend growth rate Large-Cap 1000 10.2% 14.8% 2.9% 16.4% High-Dividend-Yield 200 12.3% 14.2% 5.6% 15.1% High-Yield, High-Profitability 100 12.8% 13.7% 5.5% 18.6% High-Yield, Low-Profitability 100 12.3% 15.4% 5.6% 10.5% Source: Research Affiliates

The average volatility measure is one standard deviation of total return. This means that for the large-cap 1,000 group, your total return could be up or down 14.8% in any given year.

As you can see, the high-yield, high-profitability group had the highest total return, lowest volatility and, by far, the highest five-year dividend growth rate.



Digging deeper for quality

Brightman, Kalesnik and Kose then discussed the importance of screening further for quality, by looking at “distress risk,” which was most easily identified by reviewing debt-coverage ratios. A company’s DCR is its annual earnings divided by the sum of its interest payments for the year and debt principal coming due that year.

The researchers then searched for “accounting red flags” by focusing on increases in net operating assets. NOA is difference between net income and free cash flow. The idea is that if a company’s earnings are growing more slowly than free cash flow, it may have problems with collections, it may be using aggressive accounting to prop up earnings results or it may be forced to slow the rate of dividend increases.

After screening for those two quality factors, the researchers provided this 50-year comparison of 100 high-quality, high-yield dividend stocks and 100 low-quality, high-yield dividend stocks:

Group Average total return Average volatility Realized dividend yield 5-year dividend growth rate High-Yield, High-Quality 100 13.4% 13.6% 5.4% 18.0% High-Yield, Low-Quality 100 11.4% 15.3% 5.7% 11.1% Source: Research Affiliates

So the high-yield, low-quality group was your best bet for a higher dividend yield, but it also showed a much slower five-year dividend growth rate as well as higher volatility and a considerably lower average return.

The icing on the cake

Research Affiliates partner and head of equity research Vitali Kalesnik provided us with a list of 15 high-quality, high-yield stocks, with dividend yields, as of Friday, above 3.90%, filtered from the largest 1,000 publicly traded U.S. companies, based on annual data for 2014.

For this 2014 study, Research Affiliates screened high-yield stocks by profitability, increases in net operating assets and debt-coverage ratios.

Here’s the list, sorted by dividend yield:

On the list are many REITs, which are quite sensitive to changes in interest rates. But Research Affiliates’ screening is meant to highlight companies that will likely be well-positioned to raise dividends. If you’re holding a dividend stock that drops as interest rates rise, steady dividends can make it much easier to ride out the fluctuation over the long term.

“The interest rates are low, and if you are investing in a portfolio and want cash distribution from your portfolio, equity is an attractive asset class, because equity offers quite reasonable yields compared to fixed income,” Kalesnik said in an interview Friday. “But you do not have to just settle by investing in the headline equity index. If you look under the hood, you can select companies with even higher yields.”

Chimera Investment Corp. CIM, -2.30% , a REIT headquartered in New York, tops the list, with a dividend yield of 13.26%, based on Friday’s closing price of $14.48 and its most recently quarterly dividend of 48 cents. The company said on Thursday that it expects to maintain this dividend during the third and fourth quarters. Chimera is managed by Fixed Income Discount Advisory Co. and invests mainly in mortgage-backed securities. It had total assets of $17.3 billion as of March 31, with 41% of the total invested in MBS backed by Fannie Mae, Freddie Mac or Ginnie Mae; as well as 30% in securitized loans; and 21% in non-agency MBS.

The company earns money on the spread between the yield on its investments, which can be boosted by having been purchased at heavy discounts in the aftermath of the housing crisis. It also boosts returns by using leverage, which means it may be especially volatile when the current period of unprecedented low short-term interest rates comes to an end.