Generating Income Without Bonds
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
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 (NYSE: EXC) which yields 6.86%, Duke (NYSE: DUK) which yields 4.5%, and Consolidated Edison (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.
Duke has been paying a dividend of $3.06 per share and earned $4.32 per share in 2012. In 2013 they are expected to earn $4.35 per share and in 2014 are expected to earn $4.61 per share. Assuming no dividend growth, Duke will be paying less than two thirds of their income in dividends in 2014. Duke's five year growth rate is projected at 3.56% which means both Duke's stock price and dividend should continue to grow in the future. Duke has also exceeded earnings expectations on their past four quarters which could indicate that their projected growth rate could be conservative.
Consolidated Edison has been paying a dividend of $2.46 and earned $3.75 per share in 2012. In 2013 they are expected to earn $3.81 per share and in 2014 are expected to earn $3.86 per share. That means if Consolidated Edison continues to pay $2.46 a year in dividends, in 2014 they will end up paying under 64% of their net income. Consolidated Edison has a lower five-year projected growth rate than Duke at 2%, but Consolidated Edison currently pays 5% less of it's income in dividends.
Dividend cuts are very often the sign of a bad investment, so I would stay away from Exelon. I prefer Duke over Consolidated Edison due to its higher growth rate, but both Duke and Consolidated Edison should grow and generate income (generate, get it?) for years to come. Both of these stocks will work well in a risk adverse portfolio. Both stocks have run recently, so to start a position I would purchase the first third here and continue to build a position as their prices begin to pull back.
Justinboucher has no position in any stocks mentioned. The Motley Fool recommends Exelon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!