'Sleep at Night' Investments, Part Two: Utility Exchange-Traded Debt Securities

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 |  Includes: AEP, ETR, NEE, T, XEL
by: Five Plus Investor

Last week I published my first article on Seeking Alpha. In it I proposed that for the high yield investor there exist certain classes of investments which allow one to both invest and “sleep at night”. The first installment detailed the advantages in price stability and steady dividends of preferred shares issued by utility companies.

Today’s second installment may seem like a repeat, but it isn’t. We are still focusing on utility companies, but instead of equities we are exploring exchange-traded bonds issued by utility companies.

The Benefit of Low Price Variance

One component of the “sleep at night” portfolio is low price variance. Some of the issues presented in this series do not have a great variance between historic high and low prices. We used the last five years as a measurement, as we all lived through 2007–2008, a time period with one of the most severe market declines on record. “Low price variance” means that the issue historically may not have provided much capital appreciation in the good times. Conversely, the issue does not depreciate as severely as common stocks during a downturn, which is the aspect that allows us to invest with a good night’s sleep.

While almost all preferred shares from financial and mortgage companies suffered crashing share prices, and many suffered dividend cuts - just like their common shares - many preferred shares from utility companies suffered less depreciation and kept their dividends intact.

Did debt instruments of financial and mortgage companies also depreciate significantly during the recent financial crisis? Short answer – yes. Even exchange-traded debt securities with stellar AA+ ratings - like GEJ issued by G.E. Capital Corporation, or HCS issued by HSBC Holdings - suffered deep, 50% or more price declines from their highs in 2007-2008.

How about debt instruments from utility companies? Just like utility preferred shares, debt instruments from utility companies also suffered less decline, as compared to either their corresponding common shares, or from any debt instruments from financial or mortgage companies

Today’s “Sleep at Night” Investment: Exchange-Traded Debt Securities

At first blush, a “debt security” sounds like an oxymoron. How can a “security”, a term associated in most investors’ minds with equities, be at the same time a debt instrument? Investopedia defines a debt security (which can also be called “fixed income security”) as “any debt instrument that can be bought and sold between two parties and has basic terms defined.” The fact that these are called “exchange traded” tells you that you find and purchase these over the stock exchange, rather than the bond market.

An exchange-trade debt security sounds like an exchange-traded fund or a closed-end debt fund, but it’s not.

  • A fund is created by an investment company; a bond is issued by the underlying company.

  • A fund holds multiple bonds; an exchange-traded bond is one singular bond note.

  • A fund comes with a manager or managers (and their associated fees!); a bond does not.

Fund holders, I acknowledge your protest at this point: “wait a minute…isn’t the risk more spread out in an ETF and CEF, so holding a single bond is more risky?” The simple (and currently unexplained) answer is – not necessarily. This is a subject that I won’t address specifically in this article (but will in a subsequent article), so just go with me when I say – many financial commentators at this time are giving caution on investing in bond funds. I encourage readers to conduct their own due diligence on this subject.

Types of Exchange-Trade Debt Securities

There are a variety of “flavors” of debt securities which are related to their ranking in payout order to shareholders. When comparing debt instruments to equities, a company’s profits are paid out first to bond holders, then to preferred share holders and lastly to common share holders. If a company goes bankrupt, bond holders (creditors) remain “first in line” for distribution of assets in bankruptcy.

For this reason bonds are considered more secure than either preferred or common shares, and offer various guarantees on repayment in case of bankruptcy. The differing “flavors” come in when looking at the various levels of payout rankings and kinds of collateralization:

  • Senior Notes – “Top of the Class”. Just as seniors are the highest ranking class in school, senior notes are the highest ranking bonds issued by a company. In the event of bankruptcy, senior bond holders are repaid before every other creditor.

  • Junior Subordinated Debt – Juniors are ranked, in bonds and in life, just under the senior class. In bankruptcy they are paid just after the senior note creditors.

  • Mortgage Bond – Just as the mortgage on your home is collateralized by the home pertaining to the mortgage, a mortgage bond is collateralized by a company’s real estate or other property holdings. In case of default, the bond holder has a claim to the collateralized property.

  • Putable Bond – Okay…we could wade into the deep water on this one, but we’ll keep it simple. This bond has interest rate protection attached. If interest rates rise after the investment date, the investor can force the issuer to redeem the bond at par value. A putable bond has a put option attached. This provision limits a bond’s potential price depreciation. If you are interested in learning more, see this link: Investing Answers – Putable Bonds

Utility Exchange-Traded Bond Shopping List

Because we only have 28 issues to choose from for utility exchange-traded bonds, and because there is a whole crop of upstart newbie bonds to choose from, the criteria we are looking for is modified somewhat from the last installment. The first chart below lists the proven bonds – older issues that lived through the 2007-2008 financial crisis. The rate of variance was upped just a little to include more choices:

  • Price variance high to low of 30% or less in the past five years

  • Current yield of 5% or higher

  • Potentially under call

The second table includes the unproven low variance choices. These are newer-issue bonds that haven’t had the privilege of enduring a major stock market meltdown. While they may be also low in variance, they also haven’t had the honor of proving themselves as a “sleep at night” choice in terms of how they will react in a market crisis.

By popular request, I will from now on address the tax-advantaged status of issues at hand. In short, due to how companies report distributions on their tax returns, some shares provide a more favorable tax status for the investor – a tax rate of 15%. While many would prefer this advantage, none of the bonds I researched, and list below, had the 15% tax advantaged rate. It would appear that these are better choices for an IRA or other tax-advantaged account, rather than a brokerage account where you will incur the full dividend tax.

For those investors who are concerned with ratings, it should be noted that all utility exchange-traded bonds found on quantumonline.com, save one from Alabama Power (ALQ, not listed) are rated favorably with a Moody’s rating of Baa3 / S&P rating of BBB or better. All have a call price of $25.00.

I would be remiss if I did not now provide a caveat emptor: most of these selections have long maturity dates. If we are anticipating rising interest rates, most bond experts recommend shorter maturity dates than what are attached to many of the selections below.

Energy Co.

Bond
Symbol

High

Low

Variance


Yield Now

Call
Date \
Matures

Call:
Under / Over

15%
Tax Rate

Alabama Power
Senior Notes

Senior Notes



ALM

ABA



$27.50

$28.14



$21.00

$21.13



24%

25%



5.80%

6.20%



2/01/2011
2/01/2046
6/14/2011
6/15/2046



over

over


no

no

American Elec.
Junior Notes

AEP-A

$30.04

$21.75

28%

7.80%

3/01/2013
3/01/2068

over

no

AT&T

Senior Notes

ATT

$27.47

$20.19

27%

6.00%

2/15/2012
2/15/2056

over

no

Georgia Power
Senior Notes

GAR

$28.19

$20.88

26%

5.93%

7/15/2022
7/152047

over

no

NextEra Energy
Junior Notes

Junior Notes



FCG

FGE



$26.97

$28.00



$18.97

$21.10



30%

25%



6.48%

7.02%



10/1/2011
10/1/2066

9/01/2012
9/01/2067


over

over


no

no

Tennessee Valley

Putable Bond

Putable Bond



TVE

TVC



$27.31

$27.36



$21.95

$21.68



20%

21%



4.52%

4.70%


No call
5/01/2029

No call
6/01/2028



under

over



no

no

Xcel Energy

Junior Notes

XCJ

$28.49

$20.00

30%

7.00%

1/16/2013
1/01/2068

over

no

Click to enlarge

Here is your list of unproven low variance upstarts:

Energy Co.

Bond
Symbol

High

Low

Variance


Yield Now

Call
Date \
Matures

Call:
Under / Over

15%
Tax Rate

Dominion

Resources
Senior Notes


DRU


$29.29


$25.31


14%


7.28%


6/15/2014
6/15/2079


over

no

Entergy AR

Mortgage Bond

EAA

$25.26

$24.71

2%

5.75%

11/1/2015
11/1/2040

just
over

no

Entergy LA

Mortgage Bond

ELB

$27.12

$23.45

14%

5.67%

3/15/2015
3/15/2040

over

no

Entergy TX

Mortgage Bond

EDT

$29.25

$25.18

14%

6.80%

6/01/2014
6/01/2039

over

no

Georgia Power
Senior Notes


GAT


$31.35


$25.30


19%


6.95%


11/1/2013
11/1/2048

over

no

NextEra Energy
Junior Notes


NEE-F


$30.13


$25.18


16%


7.62%


3/01/2014
3/01/2069

over

no

SCANA
Junior Notes


SCU


$28.94


$25.50


12%


6.89%


1/30/2015
1/30/2080

over

no

Click to enlarge

Good Buys Right Now

This is a section I hope to include in all my articles – a little guidance on what is favorably priced for a buy right now. Here’s where I’m a little sad. If we are trying to buy under call…there’s nothing I can recommend. If we’re trying to buy within 10% of the lowest historical bottom price…again, nothing. Since the market is currently strong - and so are the issues were looking at - there are no real “bargains” on the list.

Before you ask yourself - why did I read this article? - Five Plus Investor isn’t going to make hard-and-fast rules when there might be a good opportunity if we bend the rules a little.

You will notice I included the issues from Tennessee Valley Authority, (TVE) and (TVC). These are not currently yielding my typical minimum yield of 5%. However, these fall into the interesting category of “Putable Bonds” which offer interest rate and price protection. Since these are classified as “Unredeemable” they do not have a call attached. The maturity dates on these are also shorter (17 and 18 years) than any of the other choices given, which provides more protection in a rising interest rate environment than others on the list. Of the two, TVE is the better bargain. At $24.90 (as of market close on April 29th), TVE is priced within only 12% of its historical bottom, and is priced under its issue price of $25.00. TVC is priced at $25.18 and is priced within 14% of its historic bottom and is just over its issue price of $25.00.

We bent the rules a little anyway by providing a list of upstarts, and there is a clear winner there. EAA is 7 months old and has been remarkably stable. Even better, priced at $25.02, it is the closest to its $25.00 call price of any issue listed. For investors willing to risk the lack of history and the long maturity date, the 2 cents overage is negligible, especially since the call is about four years away.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.