January 23rd, 2014
by Richard Stavros
The Federal Reserve's plan to curtail its extraordinary stimulus will inject considerable uncertainty into the market over the next six months. That's why utility investors should be extremely conservative and invest in only the highest quality stocks and bonds until the market's direction becomes clearer.
What kinds of securities meet our stringent criteria? We favor stocks whose underlying companies generate strong earnings that support both long-term valuations as well as dividend growth. Additionally, these utilities must also sport solid balance sheets with manageable debt burdens.
Equally important, such fundamentally superior firms should do a better job than their peers of holding their value in the event of a short-term correction. Finally, in a rising interest-rate environment these securities will need to offer competitive yields.
The current investment climate is exceedingly tricky to analyze. Some forecasters say the US economy is on the upswing and will support rising market valuations even as the stimulus recedes. Meanwhile, other market gurus worry that the Fed is acting too quickly, as the economy may not be ready to support itself without the continuing largesse of our central bank.
Should the latter scenario prove to be the case, there could be a sharp market correction sometime in the early part of the year. A protracted selloff accompanied by other signs of a deteriorating economy could prompt the Fed to pause or even reverse its taper.
Adding to this quandary is the fact that valuations do indeed look rich according to the Shiller P/E ratio, a metric created by Nobel Prize-winning economist Robert Shiller. This indicator, which is also known as the cyclically adjusted P/E ratio, uses a 10-year average of inflation-adjusted earnings to value the stock market. Historically, the S & P 500′s Shiller P/E has averaged 16.5 over the long term (See Chart A). At current levels, the market is priced about 50 percent above its long-term average.
Chart A: The S & P 500 Looks a Bit Rich
Additionally, the market typically suffers a correction of 10 percent or more about once every 7.6 months, but it's been more than a year since that's happened, leaving some investors wondering if a sudden drop is imminent.
Some institutional investors aren't waiting around for a correction, but are already actively betting against certain sectors, including utilities. The number of shares sold short in the utilities space now stands at 14.9 million, a fourfold increase in two months, according to data compiled in early January by Bloomberg and Markit, a London-based research firm. That accounts for almost 13 percent of shares outstanding for the sector, the most since September 2009.
In 2013, Utility Forecaster focused on identifying those equities that would survive and thrive in a post-stimulus environment where earnings growth will necessarily drive valuations again. At the same time, a rising-rate environment means dividend stocks will face greater competition from fixed-income securities, such as bonds. The yield on benchmark 10-year Treasury notes climbed past 3 percent in early January, narrowing the premium that utility stocks offer in dividends to 1.1 percentage points, close to the smallest gap since July 2011, according to data compiled by Bloomberg.
As this premium narrows further, only the very best utility stocks will successfully compete against Treasuries. However, utility bonds will also offer an attractive and reliable source of income in this environment.
That's because there's a limit to how high the Fed will allow Treasury rates to rise so as to not hinder the economic recovery. While we don't know what that threshold might be, the central bank has said it expects to maintain interest rates at historic lows "well past the time" when the unemployment rate falls below 6.5 percent. And given the recent disappointing employment report, the Fed is likely to maintain its accommodative stance toward monetary easing for some time, even as the stimulus ends. In fact, some economists predict short-term rates won't rise again until 2016.
2014: The Year Bonds Have More Fun
Dividend stocks have usurped fixed-income investments as a mainstay of income investors' portfolios the past few years. But bonds are about to have their day again. Of course, bonds are an important component of any investment portfolio, as they help preserve wealth during uncertain economic times while providing a steady stream of income.
As bond yields rise, income investors will feel compelled to reallocate a portion of their portfolios from dividend stocks to bonds. As this occurs, lower quality utility stocks will see their valuations erode, which means it's prudent to reduce holdings of such names and reallocate toward bonds, while maintaining exposure to only the highest quality stocks in the utilities space.
Generally, corporate bonds tend to outperform Treasuries during a healthy economy and underperform during a sluggish economy. According to a report from Barclays, over the period from 1982 through 2010, Treasuries returned about 8.6 percent annualized versus a 9.7 percent annual gain for investment-grade corporate bonds. That 1.1 percentage-point gap in performance may not seem like much, but it's actually quite significant when compounded over such a long-term period.
There are some market critics who say that rates are too low this time around to offer the same protection as in prior periods. But the advantage of a rising-rate environment is that one can reinvest interest income at ever higher rates and, therefore, achieve steadily increasing total returns on their bond investments. And since rates are low, there really is no reinvestment risk.
Furthermore, if a strong economic rebound fails to materialize, bond investors will at least preserve their principal, as other asset classes presumably decline, while if growth does occur, income increases as rates rise. But there are risks in each scenario.
Morgan Stanley says the first risk
"is the Fed begins to taper and growth disappoints, fears of deflation rise and long-end rates drop back toward 2 percent. In this scenario, we see investment-grade credit outperforming high yield for a short period of time, but persistently lower yields would likely pull investors back into high yield and the selloff may be short-lived."
The second risk, according to the bankers, is basically the opposite of the first: Growth is much stronger than expected and the Fed is slow to reduce accommodation. Rates rise rapidly in this scenario, potentially breaching 4 percent as inflation fears surge. As a result, investment-grade credit would underperform high yield, and the selloff in long-dated bonds could persist for some time as the Fed struggles to rein in inflation without choking off growth. That's why investors should have a decent balance between high-quality utility stocks and investment-grade fixed-income investments.
Nevertheless, at least one bond expert does not believe such uncertainty will deter investors. A bond expert told industry journal, Public Utilities Fortnightly.
"Fixed-income investors will likely take a more nuanced and differentiated approach to investing in utility bonds. In an environment characterized by low absolute rates and extremely tight spreads, utility sector bond investors will likely look for differentiated performance by searching for opportunities they believe are attractive from a risk-reward standpoint,"
He believes each investor will find an individual comfort zone in this new environment, but some approaches include emphasizing transmission and distribution (T&D) names over integrated names, and adjusting the mix of first mortgage bonds versus unsecured bonds. "With a number of pure wires companies trading right on top of integrated utility names-with generation exposure-utility investors might ask themselves whether taking the perceived lower risk T&D name makes more sense than buying a comparably integrated name at the same spread or for a pick-up of a few extra basis points," he noted.
Bonds of All Shapes and Sizes
Over the past few years, utilities have issued quite a bit of debt to fund their large capital expenditure programs. So there's no shortage of bonds from which to choose. And some utility bonds have sold off in anticipation of higher Treasury yields, which has created some enticing opportunities.
Last August, PG&E Corp (NYSE: PCG), issued a callable 30-year bond (due Aug. 15, 2042) that yielded 3.75 percent at 99 (CUSIP: 694308HA8). But six months later, the bond was trading at a discount of 86.76 and yielding 4.586 percent, according to the last trade recorded by FINRA-Morningstar.
Similarly, Ameren Corp (NYSE: AEE) in August issued a 10-year bond (CUSIP: 02361DAL4) that yielded 2.7 percent at 99.96, and six months later was trading at 95.66 and yielding 3.281 percent, according to FINRA-Morningstar.
While the PG&E and Ameren bonds are callable, a feature that can be problematic in a low-rate environment when investors depend on every dollar and are loath to lose their higher rate, in a rising-rate environment this is not an issue.
Investors can research these and other bonds at InvestinginBonds.com, a free website maintained by the Securities Industry and Financial Markets Association.
Many market prognosticators have argued that this year investors should focus on the short end of the duration curve. Duration, of course, is the formula that takes into account a bond's par value, coupon rate, yield to maturity, and the number of years until the bond matures.
In essence, duration tells you how much a bond's price will move in response to each percentage point change in interest rates. According to a recent BlackRock report, if the economy continues to gather steam and we see more upward rate pressure this year, it could lead to a flattening of the yield curve: The long end won't move as much since it already had a big reset last year, but the two-to-five-year range could be where rates rise the most.
But this discussion is really for those investors who may want to take advantage of pricing opportunities. According to a standard text on bond investing,
"If you hold an individual bond to maturity, or if you have no intention of selling your bond anytime in the near future, such fluctuations are less important than if you plan to collect your money and run."
Meanwhile, in addition to investor-owned utility bonds, for those seeking tax benefits and the highest level of safety, there are federally owned energy companies that offer fixed-income investments. Take for example, the Tennessee Valley Authority (TVA), a self-funded, but wholly-owned, government corporation.
TVA's bonds are backed by the revenues of one of the largest power systems in the US and carry the highest ratings. "That's something no other power company can offer," said Tammy Wilson, TVA's vice president and treasurer. It should be noted that TVA bonds are not guaranteed by the US government, but the TVA Act of 1933 grants power bond investors first pledge of payment from net power system proceeds. TVA power bonds also carry a state and local income tax exemption.
In discussing the value proposition of TVA, Wilson noted that as the Fed unwinds its stimulus efforts,
"stable credit quality will become even more important as markets adjust."
TVA offers a variety of debt securities, including short-term discount notes (similar to commercial paper), retail long-term notes, and long-term power bonds with maturities up to 50 years, along with lease-backed and other financings.
Given the dominance of large (government-sponsored enterprises) GSE and other issuers in the triple-A space, TVA's bonds can offer a diversification benefit to investors, according to Josh Carlon, TVA's director of corporate finance.
While TVA does not comment on broad market trends, there has been more interest in shorter-term maturities from investors given the recent movements in rates, Carlon said. He continued:
"We have also seen strong interest in TVA bonds from domestic investors over the past few years. This is likely because TVA has issued larger amounts of long-dated bonds, which tend to be favored by certain domestic investors with longer duration needs. We have seen a consistent foreign demand for TVA bonds of shorter maturities (10 years and in)."
The TVA securities trade on the short-end like agency or GSE bonds, and like investor-owned utilities at longer durations. Investors will have to ask their brokers to locate these bonds, as the majority of TVA's debt securities are held by institutional investors.
The aforementioned discussion does not even begin to scratch the surface of the fixed-income world in the utilities space, as firms have begun to offer many other types of innovative debt securities. We plan to highlight more of these choices in future articles, now that fixed-income investments have new relevance to investors' portfolios.