Currently bond yields are at historical lows. The 10-year treasury yields around 2%. For a 25 year old investor like me it doesn’t make much difference, because I have almost all of my money in equities. For investors in or nearing retirement though, this is a big deal. Generally as an investor approaches retirement, their financial advisor will gradually convert their portfolio from “aggressive” to “conservative” or from stocks to bonds. The idea behind this is that bonds are generally considered a much safer investment than stocks. Once in retirement, the client can then live off of the coupons from the bonds. The problem for most people is that a 2% yield won’t cut it. At this point it is hard to see bond prices going much higher (causing yields to go lower). On the other hand, if rates begin to rise, then bonds are going to go down in value. This “conservative” approach does not have the same risk reward profile that it once did. One solution is to maintain a heavier equity position or a more “aggressive” portfolio, but hold largely low beta stocks. Risk adverse investors should look at holding utilities in their portfolio which generally have a low beta and high yield.
Utilities instead of bonds
If we are looking at utilities to replace a portion of a bond position our main goal is capital preservation, so we don’t care if the company is growing rapidly. We just don’t want a utility’s share price to fall, or even worse be forced to cut its dividend. What we do want is a utility’s stock price and dividend to steadily grow over time. So, what we have to look at is their ability to pay that dividend now, and their ability to grow it in the future.
For example, let’s compare Exelon Corporation (NYSE:EXC) which yields 6.86%, Duke Energy Corp (NYSE:DUK) which yields 4.5%, and Consolidated Edison, Inc. (NYSE:ED) which yields 4.35%. Exelon has been paying a dividend of $2.10 and earned $2.85 per share in 2012. In 2013 they are expected to earn $2.48 per share and in 2014 are expected to earn $2.28 per share. That means that if Exelon continues to pay $2.10 a year in dividends, in 2014 they will end up paying over 92% of their net income in dividends. Exelon’s 5 year projected growth rate is -6.65%, so it can’t be expected that things will be better anytime soon. Not surprisingly, in Exelon’s 4th quarter earnings release they reduced their dividend to $1.24 per share.