05 July 2011
Although yields have risen recently, investors still aren't getting much cash from fixed-income holdings. As an alternative, some people have turned to shares of utilities, those electric and gas service companies usually known for paying generous dividends. "I have just about all my clients with a certain percentage in utilities stocks," says Ray Mignone, a fee-only financial planner in Little Neck. N.Y. Even so, he doesn't consider them substitutes for bonds. Unlike bonds, which are debt instruments that will pay you their face value at a future date, utilities stocks are shares in a corporation and have no maturity.
Because utilities stocks have relatively high yields, people use them—and the funds that invest in them—as bond surrogates. But when interest rates rise and bond yields improve, dividend-paying stocks can decline in price.
In addition, there are risks associated with utilities. Since their industries are regulated, utility companies don't have the final say about what they charge for service. "They have to get approval for rate increases," notes Bruce Bills, a fee-only financial planner in Henderson, Nev. “The state regulatory commissions might be reluctant to approve them in these economic times."
And the recent nuclear-reactor fiasco in Japan is a reminder that nasty surprises can affect complex power systems.
Lower Volatility
That said, utilities do have some points in their favor. While the income from a bond is fixed and won't increase, many utilities strive to provide higher dividends to shareholders over time. And under current law, qualified dividends are taxed at the same favorable rates as capital gains, while bond interest is taxed as ordinary income.
Though they are stocks, utilities tend to exhibit greater price stability than other parts of the market. The sector's beta, a measure of volatility, has been 0.6 over the last five years. The beta of the U.S. stock market is 1, so utilities are 40 percent less volatile than the market, notes Sam Stovall, chief investment strategist at Standard & Poor's Equity Research. "Utilities are traditionally defensive, meaning that if investors get nervous about the market direction, they will gravitate toward those sectors where the demand for the products and services remains fairly static," he says.
How Much is Enough?
While past performance isn't a guarantee of the future, Stovall’s figures show that in the 11 years ending in 2010, the utilities sector of the S&P 500 index had a cumulative total return (price change plus dividends) of 70 percent, the fourth-best of the 10 sectors in the benchmark.
But Bills cautions income investors not to overdo it. "I think that investors need to be careful not to, in the pursuit of yield, overemphasize one sector, and that would include the utilities sector," he says. He stresses a total-return approach and favors equity-income funds, which might hold utilities in their portfolios, for stock investors who need extra income.
In contrast, Mignone puts 2 to 5 percent of a typical client’s portfolio into utilities funds in addition to buying broad-based index funds that also hold utility stocks.
Stocks vs. Funds
If you want utilities in your portfolio, how should you buy them? Owning individual stocks entails company risk—the danger that the specific corporation will run into trouble. If you choose to buy individual utilities, Stovall suggests you look for companies that have solid records of earnings and dividend increases, are yielding at least 50 percent more than the overall market, and don't pay out too much of their earnings in the form of dividends. You can find pertinent information on individual stocks on Yahoo Finance.
For most people, a fund is a better way to hold utilities stocks. Investors have numerous choices among actively managed utilities mutual funds and passive exchange-traded funds. ETFs are similar to mutual funds but trade on an exchange, like stocks. Costs, expressed as the expense ratio, are generally low. But remember that you might have to pay brokerage fees to buy and sell ETFs.
You can find good-quality utility stocks, Mignone says. But disasters can happen, too, and you could have a big loss, he adds. With an ETF, you can "get 4 percent, and diversification is free."