May 31, 2012, 9:18 AM.The Hidden Appeal of Dinky Dividends.

Don’t scoff at stocks with dinky dividend yields of 1% or so. Some of them may hold the key to handsome total returns in coming years.

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The broad case for dividend-paying stocks rests on surging demand for yield, combined with a tight supply of it. Over the next 20 years, as the baby boomers retire, the percentage of the U.S. population the age of 65 and up will double, according to the Census Bureau. Many investors will look to convert savings into income by purchasing investments with cash yields.

Meanwhile, America’s core “Fed funds” interest rate has sat near zero since December 2008. That’s designed to stimulate the economy, but it has also served to collapse investment yields.

Consider: A retiree who puts $1 million into 10-year U.S. Treasury notes, which hit a record low yield Thursday, generates a yearly income of about $16,000, versus an average $62,000 since 1953. Treasury coupons, unlike stock dividends, don’t grow.

The obvious response for stock buyers is to scoop up shares with high dividend yields, but there are two problems with that approach now. First, it has already worked too well. Last year, a simple strategy of selecting S&P 500 stocks with high dividend yields returned 18.5%, the highest return of more than 30 strategies tracked each year by Bank of America Merrill Lynch.

Second, there’s at least some chance that dividend taxes will jump after this year, when a 15% rate cap is set to expire (see “Preparing for a Dividend Tax Hike”). It’s unclear whether higher taxes would reduce long-term demand for high-yield stocks, but it could spook investors in the short term.

Savita Subramanian, a stock strategist at BofA, recommends shifting to a different dividend strategy: Rather than simply targeting high-yield stocks, favor those with potential for payment growth, even if their current dividend yields are modest.

That approach offers some advantages. Stocks with modest yields are less likely to be sold off on fears of a tax hike. And ones with fast dividend growth tend to be thriving companies, as opposed to some high-yielders, whose prices are low because their growth prospects have dimmed.

It might seem counterintuitive to react to today’s low yields by seeking out stocks with dividend yields of 1% or so. But if a company increases its dividend by 15% a year, payments to investors double every five years — and share prices often rise, too. Plenty of companies have room for such increases, judging by high levels of corporate cash and low spending on dividends as a percentage of profits.