Financial stocks had a huge rebound yesterday, responding to the dramatic rate cut announced Tuesday by the Federal Reserve chairman, Ben Bernanke. The gains warmed Wall Street hearts, with Merrill Lynch, Morgan Stanley, and Goldman Sachs surging more than 5% and banks such as Citigroup and Bank of America up over 8%. Short covering in some names undoubtedly spurred gains, as did an upgrading of the sector by an analyst at Bear Stearns. Another boost to the stocks might have been the realization that Bank of America yielding 7.1% and Wachovia yielding 8.3% was just too good to be true.

For those who aren’t quite sure the markets have hit bottom, looking for stocks with above-average dividend yields is one way to tiptoe back in and take advantage of the carnage.

The writer of Morningstar’s Dividend Investor newsletter, Josh Peters, says he thinks this is an excellent time to buy stocks with above-average dividend yields, including some of the banks. “There are a lot of bargains out there, and a lot of fear,” he says. “There will be some losers and there will be some winners. We’ll look back on this time a few years from now and realize that there were some clear winners.”

Mr. Peters says the spreads between high-yield stocks and Treasury bonds are hitting the highest level in many years, reflecting a widespread flight to safety. He runs a model portfolio of stocks with above-average yields and has just published a book titled “The Ultimate Dividend Playbook.” He has, according to Morningstar, recommended dozens of stocks in the category that have done well and, better yet, has missed all the duds.

That’s not to say that 2007 was a banner year for Mr. Peters or for other investors in this category. On the contrary, Mr. Peter’s model portfolio, and numerous other funds that seek above-average dividend yield, returned high current income to investors in 2007, but recorded capital losses. In fact, the funds yielding the highest current returns took the biggest hits, as financials, in particular, fell sharply. Mr. Peters’s Harvest portfolio, for instance, offered investors a dividend return of 6.8% in 2007, but saw stock prices decline by 5%, netting out to a total return of 1.8%.

What’s in store for 2008? Mr. Peters says many of the stocks that caused the poor performance in the sector may bounce back, and that most will maintain their dividends. Combined, he expects the stocks he favors to do quite well.

Overall, even with the 41% payout cut from Citibank, the third largest dividend payer, Standard & Poor’s is projecting that dividends from the S&P 500 index companies will rise 9.3% this year, a good gain though less than the 11.5% rise recorded last year. That’s a hefty forecast, given that the financial sector contributes about 28% of the total.

An equity strategist at Standard & Poor’s, Howard Silverblatt, is a big believer in history. In his view, if a company has been paying dividends for many years in a row, it will likely continue to do so. “One hundred of the S&P 500 index companies have increased their dividends for more than 10 years in a row,” he says. “Managements will go to great lengths to keep that record going.”

Mr. Peters echoes this regard for history: “Through this mess, most banks will be able to maintain, if not raise, their dividends. Many companies have a long history of dividend increases, such as U.S. Bancorp that has raised its dividend rate for 36 consecutive years or Wells Fargo that has increased its rate for 20 years, including right through the California real estate recession of the early 1990s. The management team has structured the business to be able to maintain that implicit commitment to shareholders.”

Mr. Peters cautions that buyers should look for companies with “durable income over time. Profits may go down, so you have to confidant that they will bounce back. The banks have posted big losses, but they are not evenly distributed.”

Mr. Peters thinks some banks will be able to benefit from the current turmoil in the financial markets. The stronger companies that have not taken outsized mortgage-related write-offs will be able to gain market share. “I’m pretty enthusiastic about Bank of American’s purchase of Countrywide,” he says. “Not everyone agrees but I think it’s a great opportunity.” He owns Bank of America in his model portfolio, as well as U.S. Bancorp and BB&T Corp. The latter, which yields more than 6%, is one of the 10 largest banks in the country, having grown quickly through acquisitions. Although the company has some real estate exposure, Mr. Peters says he thinks its loans are well collateralized.

For the record, financial stocks are not the only sector attracting the interest of high yield buyers. The highest-yielding sector at year-end was telecommunication services, yielding 3.5%, followed by financials, yielding 3.19%, and utilities at 2.9%. These three groups are a good hunting ground for dividend payers, as are REITs and various kinds of master limited partnerships.

Mr. Peters favors pipeline master limited partnerships such as Magellan Midstream (MGG) and Kinder Morgan Energy Partners (KMP). These companies operate pipelines that are not subject to the ups and downs of energy markets. They are organized as partnerships to avoid double taxation and currently yield 4.8% and 6.6% respectively.

Another name he likes (and owns himself) is Realty Income (O), a REIT that owns free-standing single-tenant retail facilities. The stock has come under pressure because one of its largest tenants is Buffet Holdings, which may go through reorganization. Mr. Peters, however, says he is confident management’s careful due diligence will ensure its continuing protection against sizeable losses.

High-yield stocks are vulnerable to the likely expiration in 2010 of the favorable current 15% tax rate on dividends. To achieve the after-tax equivalent of a 6% dividend yield today will require a 7.8% yield if the marginal rate rises to 35%. That’s a hefty headwind, leading managers in the space to look not just for dividends that are secure, but that also have growth potential.

As Mr. Peters says, “It’s a portfolio strategy the meets real world needs.” Like cash, for instance.

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