Lock in High Yields in this Defensive Sector

The stock market is a lot like high school. You have the super popular group (tech stocks, social media IPOs, commodity stocks) that runs the place for the time being. Then you have groups in the middle who really don’t make any waves (like a Wells Fargo (NYSE: WFC) or Intel (Nasdaq: INTC), for example). Then you have a group who lags everyone else.

And while it may be the science and computer nerds or the arty types who are stuffed into lockers on a daily basis, that group oftentimes ends up surprising everyone a few years later.

This last group, the one that lags behind everyone else, is kind of like the utility sector.

Generally treated as a boring group of stocks, utility stocks have suddenly become an interesting and attractive investment. This is because in the past three years of turmoil and uncertainty, investors have started to look for steady dividend-paying stocks for peace of mind. And because of their apparent dependability and stable cash flow, utility stocks fit the bill perfectly.

If you take a look at the chart above, you’ll see that the Dow Jones Utility Index has returned about 58% since the market’s lows in March 2009. And while this lags the market’s 70% return during that time, the going has been much smoother. And more recently, around the time of S&P’s downgrading of the U.S. debt and the ongoing news coming out of Europe regarding its debt crisis, utility stocks actually rebounded more than the overall market (4.1% compared to 21.2%).

#-ad_banner-#So what gives? Why the sudden interest in the utilities? Here are three reasons why utility stocks are poised to outperform…

1. Interest rates — Because the Federal Reserve has flooded the monetary system with an ocean of money, most investors believed Weimar Republic-style hyperinflation would ensue shortly. If this had been the case, utility stocks probably wouldn’t have performed well.

Traditionally, utility companies have relied heavily on debt financing. So if interest rates went higher, then borrowing costs would escalate. This would surely compress their margins, which would impede the stock price. And this wouldn’t bode well for the dividend. But two years later, we’re still seeing low interest rates and no inflation. In fact, the yield on the 10-year Treasury is lower than it was two years ago. In addition, Ben Bernanke, the Fed‘s chairman, has said interest rates wouldn’t be going up until at least 2013. This is a clear tailwind on the upside.

2. Energy policy gridlock — Although the United States desperately needs a more focused and concrete energy policy (regardless of what side of the political aisle you’re on, you know we do), it probably won’t happen before the 2012 election. With the exception of the recent sideshow known as the debt-ceiling debate, the market loves political gridlock. The absence of regulatory overhang is a positive condition for utility stocks. Coupled with a benign rate environment, the lack of regulatory visibility will be a nice tailwind for the sector.

3. Investor uncertainty — Utility stocks have long been the “widows and orphans” safe haven and, as long as the market remains manic at best, this appeal will broaden. Retirees with a modest risk appetite and pre-retiree boomers alike could potentially continue to hold utilities, mainly for the steady dividend income. If the appetite for utility equities remains robust, then prices will probably remain stable as long as the fundamentals follow suit.

Now, how can you participate in the utility resurgence and lock in decent yields before they become the popular kids? Here are a few good places to start…

Duke Energy (NYSE: DUK) — Currently yielding about 5.3%, Duke will become the nation’s largest regulated electric utility once its merger with Progress Energy (NYSE: PGN) is completed at the end of this year. Shareholders overwhelmingly approved the deal on Aug. 23.

Exelon Corp. (NYSE: EXC) — Another big regulated power generator, Exelon trades at a  price-to-earnings (P/E) discount to its peer group at about 10.8 and 10.3 times forward earnings. Brethren such as Southern Co. (NYSE: SO) carry a P/E ratio of 17.4, while or ConEd (NYSE: ED) carries a P/E ratio of 15.5. Exelon is also in the process of acquiring Constellation Energy (NYSE: CEG), which will give the company more scale and financial strength. The yield sits at about 4.9%. I generally like 5% or better, but in this case, Exelon’s valuation is the true attraction.

Gabelli Global Utility and Income Trust (NYSE: GLU) — Having trouble choosing? How about a nicely-managed basket of stocks? This closed-end fund (CEF) holds a handful of names handpicked under the watchful eye of value ace Mario Gabelli. Shares trade at a compelling 5.6% discount to net asset value (NAV) and yield 6.3%. Distributions are paid monthly. [See: “Want More Income? Invest in these Monthly Dividend Payers”]

The fund uses no leverage, which is refreshing in the land of CEFs, and the portfolio is relatively small, clocking in at only $64.8 million under management. This is a nice, nimble size. Why is this important? Unlike their passively-managed exchange-traded fund (ETF) siblings, CEFs rely on the skill of the fund manager. And Gabelli brings the skills necessary to pay the bills.

Action to Take — > As I said before, I prefer a dividend yield of 5% or better. But even with the 10-year Treasury yielding less than 2.3%, 4.8% is nothing to sneeze at. But, if 5% is your bogey, then don’t be afraid to wait for the yield to come to you. Patience usually pays off.

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