Is the S&P 500's Highest-Yielding Dividend Stock Safe?

Investors need to be wary of anything that looks too good to be true. Take a dividend stock with a yield of 8.6%, for example. There must be a catch, right?

Not necessarily, at least in the case of CenturyLink (symbol CTL, $25.11). The regional telecommunications company is the highest-yielding dividend stock in Standard & Poor’s 500-stock index. The 8.8% yield makes CenturyLink's stock look like an income investor's dream in this era of ultra-low interest rates. (Prices and yields as of May 10.)

When faced with such a high yield, investors should question whether the dividend is sustainable. After all, a dividend stock's yield rises as the share price declines. Perhaps the yield is high because the stock is in free-fall. Maybe the company is in trouble and will have to slash or suspend its dividend in order to stay afloat.

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In the case of CenturyLink, however, the dividend continues to appear to be a solid choice for income investors. The key is that the telecom company is already generating more than enough leftover cash from which dividends are paid. And once a pending acquisition closes, CenturyLink should have even more cash coming in to devote to dividends.

The company is in the process of merging with Level 3 Communications (LVLT), a telecom and internet services provider. At the recent Sohn Investment Conference, hedge fund manager Keith Meister of Corvex Management said the combination of CenturyLink and Level 3 will create a powerhouse in business-oriented telecom services. According to Meister, the added sales and profits resulting from the merger will shore up CenturyLink's dividend for the long haul and lift the share price.

Analysts at UBS, who rate the shares at "buy," agree, applauding the deal because it will boost revenue, lower costs and lead to increased free cash flow. Those are the cash profits after capital expenditures. "We believe the proposed Level 3 acquisition improves the fundamental outlook for the company," says UBS analyst Batya Lev in a research report.

CenturyLink's cash flow will get a further boost because existing losses on Level 3's books will allow the company to pay less in taxes, analysts note. Put it all together and UBS expects the strain the dividend puts on CenturyLink's finances to decline and stay at "comfortable" levels through at least 2021.

CenturyLink had ample free cash to cover the dividend before it agreed to the merger. Once it closes in the third quarter, the telecom company will have even more. That should be music to any dividend investor's ears, since free cash flow is what supports the dividend.

What happens to CenturyLink's share price over the next few years is another matter entirely. If it goes into a tailspin, that could outweigh any benefit from the lofty dividend. But at least investors can sleep at night when it comes to their CenturyLink income stream.