Around this time last summer, I emphasized the rare opportunity to lock in safe, handsome dividend yields ahead of rising interest rates.
Around this same time last year, the benchmark 10-year Treasury was paying a sky-high 3.0%. Today, it yields around 1.6%. This means, after taxes and some inflation, you're basically paying the government to give you your money back. And with the looming fiscal cliff and the specter of higher taxes in some form, that would make me nervous (let's face reality kids... it's gonna happen regardless of who drives the Washington bus.).
According to a report published by Credit Suisse Securities Research and Analytics, a "…drop in bond yields should in turn provide a cushion to the (utility) stocks, at a minimum, in an eventually rising rate environment."
Translation: bond yields have a long way to go to catch up with utility stock dividend yields. Bonds would have to experience an epic meltdown for the spreads between utility dividends to narrow significantly.
With this in mind, here are three reasons utilities are still great investments, along with a few utility stocks for investors looking for safety…
1. Downside protection
As I discussed in last year's article, utility stock prices are typically interest-rate sensitive. As rates rise, prices can fall and vice versa. But while I'm hesitant to utter the most dangerous phrase in investing -- "This time it's different," -- the current low interest-rate environment is historically atypical. So while a 50 basis point (0.5%) move in rates is significant, this would mean a bond yield going from 1.6% to a still low 2.1%.
Again, some utility stocks yield nearly twice that.
During the past three years, an equally-weighted basket of utility stocks that include bellwether names such as Southern Co. (NYSE: SO), Warren Buffett's favorite American Electric Power (NYSE: AEP), Duke Energy (NYSE: DUK), and Consolidated Edison (NYSE: ED) would have produced an average annual total return of 22.6%. This is not bad, considering the average annualized total return for the S&P 500 Index was -- believe it or not -- 14.9% for the same time period.
The utility basket produced superior returns with considerably less risk. The basket's three-year beta, which measures a stock's volatility in relation to the overall market, was an extremely low 0.18, meaning it's 82% less volatile than the stock market.
That's the kind of investing I like.
2. No news is good news
The country still lacks a comprehensive national energy policy and it's safe to say that the geniuses in Washington have done a remarkable job of maintaining this status quo. As I stated before, the lack of regulatory visibility could be a tailwind for the sector. And with six months to go in the election cycle, don't expect any major shift in energy policy to affect the electric utility industry.
3. How's the weather?
The nation as a whole experienced an unusually mild winter. Typically, this is the harbinger of warmer-than-normal summers. I live in the South and it already feels like the peak of summer. The result? Higher kilowatt-hour consumption supporting cash flow which, in turn, supports dividend payouts. For utility shareholders,a heat wave is a beautiful thing.
Risks to Consider: While warmer-than-usual weather throughout the country can be good for the utility sector, coastal storms aren't. Hurricane season is coming down the pike and just a couple Category 2 and a Category 3 storms are enough to knock down a bunch of power lines. Luckily, most of the bigger, regulated companies have been through this before and will be prepared.
Also, while the unusually large spread between utility dividend yields and bond rates provides some cushion, as the U.S. government races toward the much-debated "fiscal cliff,," nervousness in the bond market will likely prevail. This will bring volatility to stocks that are sensitive to interest rates, but the fatter dividend yields should provide some comfort to go along with the potential risk.
Action to take --> A yield of 4% or better from a well-known electric utility stock is much more attractive than a miserly 1.6% from a 10-year Treasury. But when it comes to utility stocks, the name of the game is "quality." Southern Co. yields around 4.1%. Duke pays about 4.3%, while Con Ed's yield is slightly below 4.0%. These are the biggest of the big and the best of the best. They're also all trading near their 52-week highs.
They're always great names in a portfolio, but because of valuations, they're probably better candidates to buy on pullbacks, so make a list. Some secondary and, subsequently, more reasonably-priced names include TECO Energy (NYSE: TE) at a near 5.0% yield , or Exelon Corp. (NYSE: EXC), which yields about 5.5% and is trading at a 17% discount to its 52-week high. For some global exposure, a nibble at British powerhouse National Grid PLC (NYSE: NGG) pays a handsome 6.0% dividend yield.