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posted on 27 January 2016

When The Sky Falls: Bonds, Utility Bonds

by Richard Stavros

Investing Daily Article of the Week

The global market turmoil in recent weeks could just be the beginning of the beginning of yet more volatility.

Although investors had been expecting that the Federal Reserve's first rate hike in nearly a decade would be accompanied by a return to growth, the new year has been a rude awakening thus far.

Fears of deflation have forced investors back into traditional safe havens such as gold, high-quality sovereign debt and U.S. Treasuries. Indeed, yields on the 10-year even fell below 2%, while some sovereign debt is actually paying negative yields.

Where should investors turn amid such uncertainty? Bonds issued by regulated electric utilities could offer investors another safe haven in this environment. Their income and stability could help investors diversify some of the usual wealth-preservation strategies that they've pursued in recent weeks.

When building a fixed-income portfolio, investors should view diversification the same way as they do when investing in equities: Diversification within the asset class is just as important.

"Creating a portfolio with material representation from all fixed-income asset classes is one of the pillars of good fixed-income investing," is the standard advice, and we believe electric utility bonds offer a compelling part of any fixed-income diversification strategy.

In fact, some high-quality, investment-grade utility bonds are yielding between 4% and 6%, and a select few can still be bought at a discount to par.

But even at a premium, utility bonds could still be a compelling investment because of how they managed to hold their value while continuing to deliver income during past periods of deflation and market turmoil.

Although many investors loathe the idea of buying a bond above par, a premium bond can still be attractive if its yield to maturity is significantly greater than current market yields - the premium would then be offset by the cash flows paid out during the remaining life of the bond.

Where the Utility Bonds Are

Although dividend stocks have usurped fixed-income investments as a mainstay of income investors' portfolios in recent years, bonds are an important component of any investment portfolio. To that end, we've been reviewing Utility Forecaster's bond sleeve with an eye toward upgrading our holdings over the next few months.

As a starting point, we used our Safety Rating System to identify those utilities with superior fundamentals, particularly those with scores between 6 and 8. While we ordinarily use our Safety Rating System to gauge the sustainability of a company's dividend, we believe it can be quite effective as an initial credit screen.

After all, if a utility's dividends are not safe, then this would be tantamount to saying that its ability to pay its debts is similarly challenged. So it stands to reason that a utility that has a high probability of paying its dividend can also pay its debts.

Of course, we won't stop there. We're also looking for higher-quality securities that have an investment-grade rating.

Naturally, there are numerous other considerations, including setting a minimum yield to maturity that's attractive for premium bonds, as well as duration, convexity, and other such details.

But the companies that scored a perfect 8 on our Safety Rating System are an excellent starting point for further research.

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