Seeking Alpha
Long/short equity
Profile| Send Message| ()  

Utilities have long been a source of income for investors. However, utility common stocks, with their traditionally ample dividend yields, have been the main source of such income for investors. But there are some better alternatives out there if you are willing to dig a bit and in this article, we'll take a look at an issue that now belongs to Exelon (EXC) and could provide your portfolio with a boost of income. That particular issue is the PECO Energy Capital Trust III (KTH).

First, we'll define exactly what KTH is. As the name suggests KTH is a trust but not in the traditional sense. KTH is a third party trust preferred which means that the trust, which is administered by a third party, issues shares and then uses the proceeds to buy the underlying debt for the trust. In this case, the underlying debt is the Subordinated Deferrable Interest Debentures Series D, due 2028. That is a mouthful so let's define what the underlying debt is and how it affects the payments of KTH.

The important thing to understand with KTH or virtually any other third party trust preferred is that you are essentially buying the company's debt. If you peel back the legal layers of the transaction you are simply buying debt of the issuing company via purchasing shares in a trust instead of directly purchasing debt. In this case, the issuing company was PECO energy but that company was merged with Exelon some years ago. Thus, this issue is now ultimately funded by Exelon.

Now that we know what KTH is we can work on describing the characteristics of it and what it means for your income. First, the underlying debentures are subordinated. This just means that in the event of a bankruptcy there are higher tiers of debt that would get paid out before KTH. This is obviously undesirable but also not unusual in the trust preferred world. It is something to keep in mind as if Exelon runs into financial trouble to the point where bankruptcy is an option, you need to head for the exits with KTH. You can judge for yourself if you think that's likely at this point but I personally don't.

Second, the interest payments on the debenture are deferrable, which means that the trust can withhold interest payments to holders of KTH for a maximum of five years before the interest must be paid. Now, if interest payments are deferred for some reason the trust must still make the payments; the issue is still cumulative so you are entitled to the interest payments, you just may be forced to wait. Again, there is no reason why this would happen unless Exelon was on the brink of bankruptcy but it is something to keep in mind. Even though deferrable interest payments are not ideal at least the issue is cumulative.

Finally, as I mentioned earlier, the trust is set to mature in 2028. This means you've got 14+ years left if you want to own this security to collect interest payments before it matures. There is a clause in the prospectus that allows Exelon to call this issue if there is an "adverse tax event" but other than that, it is noncallable. In addition, if the issue is called holders receive not only the $25 issue price but also an additional payment of $2.10 in addition to any accrued and unpaid interest payments. Thus, the call price of this issue is actually $27.10 instead of $25. With that in mind the issue being called wouldn't be such a bad thing and the additional $2.10 payment makes it undesirable for Exelon to call it in the first place.

Now that we understand what we're dealing with we can take a look at the price and yield of the issue. KTH was issued in $25 denominations that trade on the NYSE. As of yesterday's close KTH was trading for $28.00, implying a significant premium to its issue price. However, with the issue callable only at $27.10 I'd suggest that the issue price of $25 is irrelevant when considering the premium the issue trades for. Regardless, the coupon on the issue is $2 per share annually paid out in semiannual installments. Basically, at the end of April and October of each year holders will receive $1 per share of KTH owned as interest payments from the trust. And with shares currently trading for $28 the current yield of 7.14% is lower than the coupon rate of 8% but it is still a very strong yield indeed. Plus the issue is cumulative so there is some added protection there.

KTH is somewhat of a complicated issue but it also offers investors a chance to own a high-yielding utility security with strong protections built in for the off chance that there is some kind of bankruptcy event. Semiannual interest payments aren't ideal for income investors that rely on their securities to cover living expenses but in a retirement account for long-term holders, it shouldn't matter. The interest payment status of this issue also means the favorable dividend tax treatment is not in effect with KTH but again, in a retirement account that won't matter. These are simply things you must keep in mind for your own personal situation to decide if KTH is right for you or not. I like KTH for its cumulative interest payments and strong yield but it is certainly not for everyone. Plus, the added protection of the $27.10 effective call price is an extra kicker that makes this issue even more attractive.

Source: A Strong 7.1% Yield From This Large Utility