Positive potential implications: Oneok (OKE45 *****), UGI (UGI26 ****), AT&T (T25 *****), American Electric Power (AEP36 *****), Edison International (EIX33 ****), Entergy (ETR78 ****), Exelon (EXC42 ****), FirstEnergy (FE38 ****), NextEra Energy (NEE53 ****), Public Service Enterprise Group (PEG33 ****), and CenturyLink (CTL35 ***).

At the end of the year, investors may have to say goodbye to the low tax rates they have enjoyed on qualified dividends. But the long-term investment case for owning top-quality stocks that pay yields remains intact, according to Standard&Poor's Equity Research Services (ERS).



As part of former President George W. Bush's tax-cutting packages passed in 2001 and 2003, the tax rate on dividends and long-term capital gains were capped at 15%, making dividend-paying stocks an attractive option for investors who were seeking income while willing to take on the risk associated with stocks. Before the cuts, dividends were taxed at the taxpayer's marginal rate, which could be as high as 39.6%, while the capital-gains tax rate for assets held more than 12 months was 20%, and 18% for qualified five-year capital gains.



These tax rates would be reinstated if the tax cuts, which are legislated to sunset on December 31, 2010, expire. However, lawmakers may consider modifications that may include extending the tax cuts or modifying some of the tax rates in order to lessen the burden on beleaguered taxpayers. Despite the different scenarios that may play out, ERS notes that many high-quality stocks remain attractive in terms of their capital appreciation potential, and because of their ability to continue paying and growing dividend payouts.



Sam Stovall, S&P's chief investment strategist, suggests investors seeking income should focus on stocks with an average-to-high S&P Quality Ranking (QR), which ranks the growth and stability of earnings and dividends, and shares that also have a high S&P STARS rankings. Under S&P ERS' proprietary STARS (STock Appreciation Ranking System), S&P equity analysts rank stocks according to future total return potential versus the expected total return of a relevant benchmark. A stock that carries a five-STARS ranking, for example, is "strong buy" ranked at S&P. The Quality Ranking ranges from A+ (highest) to C (lowest), with D reserved for companies in reorganization.



By employing these proprietary measures to stock selection and purchases, Stovall says investors could avoid "yielding to temptation" or buying issues that offer a yield that is "just too good to be true" because the payout may actually be unsustainable.



Christopher Muir, an S&P equity analyst, notes his "strong sell" and "sell"-ranked stocks have relatively high yields, but that the shares' S&P QRs are "B" or below average. The QR denotes some skepticism that "sell"-ranked NiSource's current yield of 5.9% and "strong sell"-ranked Integrys Energy Group's dividend of 6% will endure.



"The companies are working through issues which caused their stock prices to drop, hence increasing their yield," Muir explains.



Instead, attractive standouts in Muir's gas-utility coverage universe are his "strong-buy" pick Oneok with a 4.1% yield and an S&P QR of "A-" or above average, and his "buy"-ranked pick UGI, with a dividend yield of 3.7% and an S&P QR of "A" or high.



Muir thinks even if the dividend tax rate rises, higher quality utilities will not change their dividend payout ratio targets. "Those utilities that were increasing their dividends before such a tax change are likely to continue increasing their dividends at the same rate afterwards, all other things being equal," he says.



But he also thinks that utility-sector stock prices may already be reflecting some investor concern to a potential increase in the dividend tax rate. Stock prices for the sector have pulled back 4.5% since the beginning of the year, according to July 16 data. The entire S&P 500 utilities sector's average yield is currently 4.5%.



Justin McCann, an S&P equity analyst, favors "strong-buy" ranked American Electric Power, whose S&P QR is "B." Its dividend is currently 4.8%. He also likes the following buy-ranked companies: Edison International pays 3.8% and has a "B" QR, Entergy's yield is 4.3% and it has an "A" QR, Exelon pays a 5% dividend and has a "B+" QR, FirstEnergy's yield is 5.9% and its QR is "A-", NextEra Energy recently paid 3.8% and has an "A" QR, and Public Service Enterprise Group, a "B+" QR-ranked company, pays 4.1%.



Todd Rosenbluth, who heads telecommunications and utilities equity research for S&P, points out investors may also want to consider telecommunications stocks. The average dividend yield for an S&P 500 Index Telecom Services stock as of July 19 was 6.3%, about triple that of the broader market.



"Companies such as AT&T and CenturyLink have increased their dividend payments annually for well over a decade and despite potential tax changes and capital-spending efforts, we expect them to have the free-cash flow to continue that trend," he says. S&P's Quality Ranking for both AT&T and CenturyLink is "B+" or "average."



--ISABELLE SENDER, S&P Editorial

28-Jul-2010 14:02:17 (15694755)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.