With interest rates at embarrassingly low levels and with stocks at all-time highs, many investors have turned to key dividend-paying stocks to generate income and hopefully to achieve long-term upside. The week of August 12 brought the Merrill Lynch RIC Report, which is effectively a culmination of the firm’s top research ideas, views and advice for clients. The one common theme throughout this report was where to find yields.

Before getting into stocks and sectors, it is important to realize that roughly 25% of the bonds in developed nations had negative yields. That is effectively a safety tax, and it erodes capital through time.

The first issue to consider is that there has become a role reversal between stocks and bonds, whereby bonds were the source of price appreciation and stocks have become a better source of income. Quite simply, this is the inverse of every investing and finance class you ever took. In fact, at the end of July, it was the case that 65% of the S&P 500 members had dividend yields that exceeded the 10-year Treasury yield.

What Merrill Lynch is focused on now is a mix of high-quality bonds and dividend-paying stocks. They feel that investors should look at some stocks as sources of income, but they need to keep in mind the extra price risk and volatility of returns. In high-quality bonds, they see income but see very limited price appreciation.

It is important to understand that the so-called yield trade is not really new. In fact, utilities and some defensive stocks now trade with massive market valuation premiums. Issues to consider are that returns on stocks are more volatile through time, not all yields are created equally (do not forget that!) and defensive sectors usually are the first place investors look for yield. Financial stocks, including banks and real estate investment trusts (REITs), also may be an overlooked source of yield. Integrated oil stocks can be a steady source of income, but master limited partnerships have a higher risk profile.

Merrill Lynch has a proposed equity income portfolio for investors here. There are other stocks rated with Buy ratings that might have higher yields in the Merrill Lynch coverage universe, but these are the ones with what are deemed normalized or safer yields than might be found elsewhere. 24/7 Wall St. has taken the highest yield from each sector in that model income portfolio, and all but two have Buy ratings, and we eliminated the companies that were not based in the United States.

McDonald’s Corp. (NYSE: MCD) was the top U.S. pick in the model income portfolio’s consumer discretionary stocks. Its yield was 2.99%. Merrill Lynch has a Buy rating on McDonald’s, and its price objective of $140 compares to a current price of $119.52, and is against a consensus analyst price target of $130.29.

CenturyLink Inc. (NYSE: CTL) is the highest yield of the telecom sector at 7.23%, an average of three points higher than AT&T and Verizon. CenturyLink has a Buy rating at Merrill Lynch, and the firm’s price objective is all the way up at $42. The consensus price target is $29.23, just under the current share price of $29.96.

International Business Machines Corp. (NYSE: IBM) is the top income portfolio pick in technology and IT, with a 3.43% yield. Merrill Lynch actually has only a Neutral rating on IBM, but it has a $170 price objective. IBM’s current price of $161.95 is against a consensus price target that is lower at $153.90.
Pfizer Inc. (NYSE: PFE) is the highest of the U.S. health care yields for the model income portfolio at 3.39%. Merrill Lynch has a Buy rating and a $40 price objective. Pfizer’s current share price is $34.98, and its consensus target price is $39.35.

PPL Corp. (NYSE: PPL) is the firm’s highest dividend yield in utilities, with a 4.13% yield. Shares are currently trading at $36.26 and have a consensus analyst target of $38.77. Merrill Lynch’s Buy rating is much more optimistic at a $42 price objective.

PACCAR Inc. (NASDAQ: PCAR) was the high yield in the industrials sector, at 4.07%. Merrill Lynch has it rated as Buy with a $67 price objective, which compares to a share price of $57.71 and a consensus price target of $57.00.

Ventas Inc. (NYSE: VTR) was the highest financial company yield in the model portfolio at 4.34%, but this is actually a health care REIT. Ventas trades at $74.43, and Merrill Lynch has a Buy rating and $79 price objective.

MetLife Inc. (NYSE: MET), if you wanted to focus on true financial players, has the highest yield of the financial stocks in the model income portfolio at 3.99%. Its Merrill Lynch rating is Buy, with a $50 price objective. The consensus price target is $49.00, and a current share price is $39.76.

Spectra Energy Corp. (NYSE: SE) was shown with the highest yield in the energy sector’s three picks in the model income portfolio, coming in at 4.43%. Spectra’s rating is actually now Neutral at Merrill Lynch, and the current $36.36 trading price is against the firm’s $36 price objective.

Philip Morris International Inc. (NYSE: PM) is a U.S.-based company but generates all of its income outside of the United States. It had the highest yield of the five consumer staples picks in the model income portfolio at 4.12%. The stock has a Buy rating at Merrill Lynch, and the firm’s $115 price objective is against a $99.00 share price.

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If there is one thing that investors should cheer here is that the gains are expected to continue through time. Merrill Lynch’s Savita Subramanian, the firm’s U.S. Strategist, has a 2016 year-end S&P 500 target of 2,000 — and a 10-year S&P 500 target of 3,500!

Merrill Lynch also remains positive on many closed-end mutual funds as a good source of income. Still, the firm warns that the net asset value discounts in many sectors have narrowed significantly since last summer. Within the fixed income portion of closed-end, select senior loan funds were shown to have an average distribution rate of 5.9% and multi-sector fixed income funds were at 9.2%. Equity closed-ends in the covered call closed-end funds were at average discounts of roughly 6.4% and had distribution rates of 9.4% on average. The tax-free municipal bond sector of closed-end funds had average yields of 5.3%, but the firm noted that investors may be better off waiting for more attractive entry points.

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