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The Southern Company (SO), Xcel Energy Inc (XEL): Utilities – Today’s Best Bond Alternative

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To refer to any stock or equity as an alternative to bonds or fixed income is sure to stir up the ire and consternation of many professional and individual investors alike who deem themselves prudent.  Frankly, under normal circumstances I would tend to agree.  But the nature of bonds and other fixed income instruments are not normal today.  With today’s extreme, and in the minds of many, contrived low level of interest rates, the risk profile of bonds and fixed income are far from typical.  More simply stated, the currently extreme low level of interest offered by bonds and other fixed income instruments have dramatically altered, and I contend, increased their risk profile.

Consequently, the safety gap between equity and debt instruments has, temporarily at least, narrowed.  In other words, I do not believe that fixed income offers the large safety advantage over equities that it normally has, or once did.  As I will attempt to illustrate, the equity versus bond safety comparison is most relevant to the specific sector 55 Utilities.  But again, this may only prove to be a temporary phenomenon, but as we sit today, fixed income is clearly no longer the safe haven it once was.  When interest rates eventually rise, and I’m certain that they will, but not certain as to when, bond prices, especially longer-term bond prices, will fall.  This potential price volatility could be as dramatic, or even worse, than we have seen with our worst bear markets in stocks.

In addition to the safety factor, the second primary reason to invest in bonds was their high yield.  Under normal circumstances, bonds often offered interest yields that were multiples of the dividend yields available from the average dividend paying common stock.  Therefore, in addition to the safety factor, a balanced portfolio comprised of stocks and bonds was not only prudent, but also generated a higher level of income.  This was especially relevant to retired investors in need of income to live off of.

However, in today’s world, high quality blue-chip dividend paying stocks offer a yield advantage over fixed income. First of all, and in many cases, their yields are higher than what is available from even a long-term bond.  Second, best-of-breed dividend paying blue chips, purchased at sound valuations, provide the opportunity for capital appreciation and an increasing dividend income stream.  Therefore, although loaning your money at interest was once a wise investment decision, today ownership in many ways has the upper hand over loanership.

The Public Utility Holding Company Act of 1935 (PUHCA)

In 1935, under the urging of then-President Franklin Delano Roosevelt (FDR), Congress passed The Public Utility Holding Company Act with the purpose of regulating electric utilities.  This limited electric utility companies to only providing electricity within a limited state-by-state geographic area.  Therefore, and from that day forward, electric utilities became a regulated, quasi-public/private industry.  I contend that the regulation of this industry created a two-edged sword, so to speak.  On the one hand, the regulated aspect of their business provides the safety factor over most other sectors that I alluded to earlier.  But on the other hand, regulation has placed a brake on their ability to grow.  Consequently, regulated public utility companies typically offer below-average earnings growth.  However, this is partially compensated for by the above-average current yields they offer.

The Utilities Sector

This is the eleventh and final article in a series of articles designed to find value in today’s stock market environment. It is the tenth of 10 articles covering the 10 major general sectors. In my first article, I laid the foundation that represents the two primary underlying ideas supporting the need to publish such a treatise. First and foremost, that it is not a stock market; rather it is a market of stocks. Second, that regardless of the level of the general market, there will always be overvalued, undervalued and fairly valued individual stocks to be found.

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