10 Highest Dividend Stocks of the S&P

No surpise, but tobacco and utilities dominate list

The S&P 500 is one of the most followed stock market index in the world. Mutual fund managers benchmark their returns against it, yet somehow studies show that the vast majority underperforms the index in any any given year. There are many ways to invest in the S&P 500, including mutual funds like the Vanguard 500 Index Investor (MUTF: VFINX), exchange traded funds like theSPDR S&P 500 ETF (NYSE: SPY) or even stock index futures.

I benchmark my dividend income against the S&P 500. Many of the best dividend stocks in the world have a substantial weight in this important stock market barometer. With its average yield of 1.70% however, many dividend investors choose to ignore the index, and instead focus on its components.

It is interesting to note that 386 companies included in the index pay dividends. The average yield on those is 2.30%. Below I have highlighted the ten highest yielding dividend stocks of the S&P 500:

Altria Group (NYSE: MO) engages in the manufacture and sale of cigarettes, wine, and other tobacco products in the United States and internationally. This dividend champion has raised distributions for 43 years in a row. The company has a forward dividend payout ratio of 76%. Yield: 6.10% (analysis)

AT&T Inc. (NYSE: T) , together with its subsidiaries, provides telecommunication services to consumers, businesses, and other service providers worldwide. This dividend champion has raised distributions for 27 consecutive years. The high dividend payout ratio, and the fact that the company is in a highly competitive industry cast a shadow on the sustainability of the distribution payment. Right now the dividend payout ratio is 72% based off forward 2011 EPS. If the acquisition of T-Mobile goes through, the payment of $25 billion dollars in cash could potentially jeopardize the current dividend. (analysis)

Frontier Communications Corporation (NYSE: FTR) a communications company, provides regulated and unregulated voice, data, and video services to residential, business, and wholesale customers in the United States. Between 2004 and 2010 the company paid a quarterly dividend of 25 cents/share. Last year however it cut the distribution rate by 25% to 18.75 cents/share. The company has been unable to cover its dividend out of earnings since 2006. More than two-thirds of its distributions are non-taxable as they are essentially a return of capital. Yield: 9.40%

Windstream Corporation (NASDAQ: WIN), together with its subsidiaries, provides various telecommunications services primarily in rural areas in the United States. Since 2006 the company has paid 25 cents/share every quarter. Windstream has been unable to cover its dividends from earnings in every year since 2008. One the bright side cash flow from operations has been relatively stable, although the company has ramped up capex spending in recent years. Yield: 7.90%

CenturyLink, Inc. (NYSE: CTL), provides a range of communications services, including local and long distance voice, wholesale network access, high-speed Internet access, other data services, and video services in the continental United States. The company is a member of the elite dividend aristocrats index, and has raised dividends for 37 consecutive years. In comparison to the previous two telecom players, CenturyLink has been able to cover its distributions from EPS, although its payout ratio is a scary 92.70%. Yield: 7.20%

Reynolds American Inc. (NYSE: RAI), through its subsidiaries, manufactures and sells cigarette and other tobacco products in the United States. The company has raised dividends for 7 years in a row. The company has managed to double EPS over the past decade, and raise dividends by 9% per year as well. The forward dividend payout ratio is 79.70%. Yield: 6.20%

FirstEnergy Corp (NYSE: FE) is involved in the generation, transmission, and distribution of electricity, as well as energy management and other energy-related services. The company has maintained its dividend payment since 2008. It’s dividend payout ratio however is at 69.40%, which is sustainable for a utility company. Yield: 5.90%

Pitney Bowes Inc. (NYSE: PBI) provides mail processing equipment and integrated mail solutions in the United States and internationally. The company is a member of the dividend aristocrats index and has raised distributions for 29 years in a row. Yield: 5.90%

Pepco Holdings, Inc. (NYSE: POM) operates as a diversified energy company. It operates in two divisions, Power Delivery and Competitive Energy. The company cut dividends by 40% in 2001 to 25 cents/share, and has since raised them by 8& to 27 cents/share. Based off forward 2011 EPS, the payout ratio is over 85%. Yield: 5.80%

Lorillard, Inc (NYSE: LO), through its subsidiaries, engages in the manufacture and sale of cigarettes in the United States. The company has paid a rising dividend since becoming a separately traded company in 2008. It yields 5.40% and has a high dividend payout ratio as well.

It is evident that the highest yielding stocks in the S&P 500 include sectors such as telecom, tobacco and utilities. All of the top ten companies have very high dividend payout ratios. This increases the risk of a dividend cut , as any decline in earnings would make it impossible to maintain the high distributions. Of particular concern are the telecom companies, since the cash cow businesses of telephones is a dying one. The cell phone industry is highly competitive and is becoming a basic commodity, since customers could expect similar levels of service, and similar prices as well. The only differentiator could be phones offered, but this is a short-lasting advantage, as new phones are introduced and it is impossible to tell which ones would be embraced by consumers.

The tobacco business is also in decline, as more people are starting to realize the health effects of smoking on their well-being. In contrast with telecoms however, tobacco companies have strong pricing power and a loyal customer base, which is addicted to its products. While taxes are raised each year on cigarettes, the levels of price increases that cigarette makers generate more than offsets the decline in consumption by customers. In addition, while there might be speculation that unfavorable court rulings could potentially make all tobacco companies bankrupt, this is highly unlikely. The taxes that tobacco products generate fill in government coffers with billions of dollars worldwide, and tax increases are favored by the electorate. It would be difficult to replace the tax revenues from tobacco products if they were banned.