In consideration of today’s low interest rate environment, fixed income securities offer little in the way of return. Moreover, the safety characteristics normally associated with fixed income are also potentially upside down. Since early 1982, the interest rates available with fixed income have been in a continuous freefall. This has presented both good and bad news for the conservative investor desirous of a high and safe income stream on their portfolios.
The good news is that bond prices move inversely with interest rates. Therefore, when interest rates drop, as they have done since 1982, the prices of previously issued bonds will rise. Therefore, fixed income investments, primarily bonds, have provided the opportunity for high yield and either capital appreciation or at least stable prices. This falling interest rate trend has gone on for more than three decades, and as a result, fixed income returns have been abnormally strong and even high.
However, the first part of the bad news is that fixed income investors need to understand that previously issued bonds will move to a premium valuation as rates are dropping, but will eventually move back to par when they mature. Consequently, the only way to lock in capital appreciation in addition to your interest income would be to sell your bonds before they mature. Otherwise, temporary capital gains created by falling rates will inevitably dissipate to breakeven levels. As a result, investors that hold bonds to maturity will in effect suffer losses of purchasing power due to inflationary forces.
On the other hand, the additional bad news is that falling interest rates result in the inability to reinvest in newly-issued fixed income instruments at rates that are attractive. But the worst bad news is that those investors purchasing fixed income at today’s extremely low rates are exposing their capital investments to potential losses in a rising interest rate environment.
Investors need to understand that bond prices fluctuate just as stock prices fluctuate. If future interest rates move higher, and if that were to happen quickly, originally issued bond prices could drop just as much as stock prices did during the Great Recession. Bonds are considered safe because they mature at par; however, bonds are also liquid. Therefore, bond prices can, and do, fluctuate between their issue date and maturity.
Fairly Valued Utility Stocks for Income and Safety
Consequently, and as the result of the fixed income dynamic discussed above, I have been, temporarily at least, eschewing fixed income. In other words, I have been recently looking for viable alternative income-producing opportunities. Importantly, I am just not focused on finding higher income streams; I’m also concerned about finding income-producing alternatives with reasonable safety characteristics. I believe that carefully selected utility stocks can fit the bill, as long as they are purchased at sound or attractive valuations.
Stocks and bonds are different investment types and therefore possess different investment merits and characteristics. I believe it would be a stretch to state that utility stocks are perfect fixed income alternatives.On the other hand, utility stocks, when purchased at sound valuation, do possess and/or share characteristics with bonds that are similar enough to consider them a reasonable alternative.
When interest rates are at normal levels, bonds pay higher interest income than most blue-chip dividend paying stocks provide in dividend yield. Furthermore, since bonds provide an implicit guarantee of returning principle at maturity, they also provide a level of safety not normally associated with stocks. However, it is also true that all dividend paying common stocks are not the same.
Utility stocks are generally regulated monopolies, and as such, have a history of producing reliable and consistent earnings growth and above-average levels of dividend income. Nevertheless, even though the earnings growth of utility stocks is generally consistent and reliable, earnings and dividends generally do not grow very fast. Regulation provides consistency and a level of reliability, but at the expense of higher or above-average growth potential.
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