A Utility Issue With A Rising Yield And 25% Potential Upside

| About: Dominion Resources, (D)

Dominion Resources (NYSE:D) is a regional utility provider based in Virginia. Like most utilities it has issued its fair share of debt over the years and income investors also certainly appreciate the common stock's ample dividend yield. However, with the fear of a Fed taper on the table in a very real way, income investors that hold fixed rate securities such as bonds may be a bit apprehensive. To combat this, Dominion issued a security in 2005 that I believe could provide your portfolio with some interest rate risk mitigation and upside to boot.

The security I'm referring to is the Synthetic Fixed-Income Security 2005-06, Floating Rate Dominion Resources Inc. (GJP). The title of this security is a mouthful so we'll take a look now at what exactly this thing is. Basically, this security is a floating rate trust preferred that pays monthly interest based upon certain criteria. It is based on a debt issue, the 5.95% Series B Senior Notes due 2035, and pays interest to holders of GJP based on the average of the 3 month Treasury plus 1.15%, subject to a 3% floor and an 8% ceiling.

What does all of that mean? GJP is a trust preferred security which means it pays interest based in part on the underlying debt that Dominion issued; that debt is the 2035 note mentioned above. However, instead of paying a fixed interest rate like most preferreds, this one has a floating rate feature. It pays holders of GJP based on the three month Treasury bill rate plus 1.15% subject to the ranges I specified above and it pays on a monthly basis, not quarterly or semiannually. Since this is a floating rate issue you wouldn't want to own this while interest rates are falling because you'll be subject to not only capital loss due to falling rates but less interest received due to the floating rate nature of this issue. However, this is exactly why I'm bullish on GJP. With the Fed set to taper in the very near future, one would expect interest rates to rise from the current zero lower bound. When this happens and the three month bill rises, GJP should not only begin to pay more interest but also appreciate in value as investors realize its interest rate has reset higher.

A couple of other notes on GJP include the fact that it is callable at any time. This means that Dominion can redeem this issue any time it likes at $25 per share but with shares trading at $19.55 as of this writing that would be a tremendous outcome from GJP holders. While I don't think Dominion would call this issue right now, it certainly could once rates reset higher. But the reason I don't think it will is because GJP is currently only paying roughly 3.8%. Because of the floating rate interest payments on GJP when rates are depressed as they are now, holders of GJP suffer with less interest received. The past twelve months have seen monthly payouts of around 6.2 cents per share on average, or roughly 3.8% of the share price. However, with interest rates set to rise due to a confluence of factors, we should see that payout gradually rise over the next several years.

The other part of this equation is that when interest rates do rise Dominion may be more inclined to call this issue, providing holders that get in now with a sizable capital gain. Make no mistake; this isn't going to happen overnight. A position in GJP is an investment in rising interest rates and will likely be rewarded over several years with a combination of capital gains and rising monthly distributions. But if the rising interest rate scenario so many expect actually plays out, GJP holders could benefit from the double tailwind of capital gains and rising payouts.

GJP is a somewhat complicated issue that, once understood, could provide your income portfolio with not only some much needed interest rate risk mitigation but also a way to benefit from such an event. While the current yield of GJP alone doesn't make the issue worth owning, I believe that a rising interest rate environment could offer holders capital gains of 25% or more and a rising payout up to a potential 8% depending on short term rates. Plus, the Baa2/A- rating and callable nature of the issue makes it safer than many other floating rate alternatives in the market. While GJP isn't for everyone it is still worth a look as an investment in higher rates down the road.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I may go long GJP at any time.