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Utilities The Preferred Way

By Roger Conrad on May 23, 2007

Neither bond nor equity but with elements of both, preferred stocks are Wall Street’s third way to wealth. And, as the road less traveled, the yields are often sweeter and the risks less severe.

No sector is as target-rich for preferred stocks as utilities. Electric, gas, water and telecom companies are always in need of capital to build vital infrastructure.

As we pointed out in the April 25, 2007, issue, demand for cash presents a particular challenge in the decade ahead. Preferred stocks—which pay fixed rates like bonds, on a quarterly basis like stocks—will continue to play a big role in meeting it.

As is the case with all fixed income, the best bargains are among the lower-rated issuers. Yields are as much as 2 percentage points higher. And there’s upside as issuers make their way toward better health.

In contrast, AAA-, AA- or even A-rated securities’ lower perceived credit risk means they’re far more affected by interest rate swings, and they can get clobbered if ratings are cut.

Improvement is practically a given with lower-rated utilities. In fact, no matter how badly utes have been run into the ground, they’ve always been able to bounce back by getting back to basics, i.e., slashing debt and pulling back to the core business of providing essential services.

The utility preferred shares and closed-end mutual funds in the table “Utility Preferred Picks” aren’t flat on their backs. There’s still plenty of room to ride them and their still-generous yields to recovery.

Solid And Surging

Three of the “Utility Preferred Picks” are currently in the Income Portfolio. The rest are fine buys for even the most conservative investors looking for good yields.

AES Corp Preferred C is a high-yielding bet on the rapid growth and emerging financial recovery of clean power company AES. The preferred still trades at a steep premium to its conversion value of 1.4216 AES common shares, which have stalled as Wall Street waits for a pending restatement of recent financials.

Upside is likely to resume as that issue is resolved and the company’s major investment in wind and new power transmission infrastructure starts to pay off. AES Corp Preferred C is a buy up to its call price of 50.44.

Central Vermont Public Service Preferred shares could get an immediate leg up if the utility is acquired by a more creditworthy entity in coming months. The company, however, is well on track to regaining investment-grade ratings on its own as it makes key investment in reliability and clean power, improves relations with regulators and cuts debt.

Interest expense was reduced 13 percent in 2006 and looks headed lower. Central Vermont Public Service Preferred pays a qualified dividend of 6.5 percent and is a buy up to 80.

Consumers Energy Preferred B’s issuer CMS Energy is the latest textbook case of a once-lost utility that’s finding its way again, enriching investors in the process. This year alone, the company has unloaded underperforming non-utility assets for some $1.8 billion in cash to reduce debt and reinvest in the core Michigan utility business.

With first quarter interest expense coming down 14 percent, an investment-grade credit rating may be only a matter of months, bringing an even higher price for the preferred B. Buy Consumers Energy Preferred B up to 90.

El Paso Energy Preferred C’s parent has also been getting back to basics the past few years, cutting debt from a 2003 peak of $23 billion to less than $12 billion today and shedding disastrous investments in electric power marketing and other ventures.

El Paso’s core business is a still-expanding base of more than 43,000 miles of energy pipelines connecting all the major producing and consuming regions of the US. The natural gas production arm has returned to conservative growth, and the company’s credit outlook is positive. With an upgrade imminent, El Paso Energy Preferred C is a buy up to 43.

Virginia Power Capital Preferred A is the most conservative of our picks and the most at risk currently to being called. Parent Dominion Resources is due a rating boost with the sale of its natural gas and oil production arm. Virginia Power Capital Preferred A is a buy on dips to 25.

With sector analysts still fixated on the erosion of the traditional phone business, the telecom industry’s financial power is still hugely undervalued. That spells an opportunity in fixed income as well as the common shares that populate our portfolios.

April Income Portfolio addition Comcast Corp 7 Percent Preferred is benefiting from its issuer’s double-digit cash flow growth as the cable giant adds new entertainment, high-speed Internet and telephone customers. Already investment grade, Comcast Corp 7 Percent Preferred yields more than 6 percent to worst call and is a buy up to 27.

Cincinnati Bell Preferred B draws much lower ratings but is on a similarly positive course. Cincinnati Bell—which was nearly bankrupted by over-reaching executives in the late 1990s—has found a winning formula from bundling wireless, wireline, broadband and even home security services, boosting operating income 34 percent last year.

It may be years before the common stock climbs enough to make convertibility worth anything. But even if that never happens, the increasingly solid yield makes Cincinnati Bell Preferred B worth a buy up to its call price of 50.34.

The Fund Approach

If you don’t want to buy preferreds individually, the best choice is a good closed-end fund. Our table lists three, one of which is currently in the Income Portfolio: Flaherty & Crumrine Preferred Income Fund.

Flaherty & Crumrine’s chief strategy is maintaining a stable net asset value, which has smoothed out its ups and downs since inception in January 1991. The biggest hazard for buyers historically has been paying too high a premium for shares, but even those who purchase inconveniently have eventually profited from the fund’s big, steady yield. Buy Flaherty & Crumrine Preferred Income Fund up to 17.

John Hancock Patriot Preferred has also been run conservatively since inception in 1993, a fact enforced by its lack of a losing year this decade. Unlike Flaherty & Crumrine Preferred Income, it trades at a discount to net asset value, but that’s been a normal condition in recent years. Buy John Hancock Patriot Preferred up to 14.

Nuveen Quality Preferred is the newest and most aggressive of the trio because of less reliance on preferreds and greater exposure to non-US securities. It was also by far the best performer last year, with a total return of nearly 30 percent, and has the fattest yield as well. Buy Nuveen Quality Preferred up to 15.

Roger S. Conrad is Associate Editor of Personal Finance and Editor of Utility Forecaster, Canadian Edge and Utility & Income, and is Co-Editor of Maple Leaf Memo. For complimentary subscriptions to U&I and MLM, click here.

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