DUKH: A 6.3% Yield And 20%+ Upside From A Large Utility

| About: Duke Energy (DUK)

Utility investors often are those that are seeking strong, stable sources of current income. Frequently the best place to find such sources of income are utility common stocks and while it is the case that utilities have traditionally been the place to get income in the stock market, there are better instruments to do so that investors often overlook. One such instrument, still in the world of utilities, is the Duke Energy (NYSE:DUK) 5.125% Junior Subordinated Debentures due 2073 (DUKH). In this article, we'll take a look at DUKH to see if it could be a fit for your portfolio.

To start, we'll define exactly what DUKH is. This is an exchange-traded debt instrument, which means that Duke issued debentures but instead of having them trade on a traditional bond exchange, which is outside the reach of many retail investors, the debt was issued in $25 increments and trades on a stock exchange. This means the debt is readily accessible to anyone with a brokerage account and also has higher volume, all else equal, than those debts that are traded on bond exchanges in much larger, illiquid lots.

In this case, the debt instrument being traded is the 5.125% debenture due 2073. Essentially, this is simply a subordinated debenture in the traditional sense; it pays quarterly interest payments and has a stated maturity date. The coupon on DUKH is $1.28125 per year and at the $25 issue price, works out to 5.125%, the same coupon as the underlying debenture. However, interest rates have moved up since this debt was issued earlier this year and DUKH now trades at a significant discount to its issue price at only $20.36. As a result the current yield on DUKH is actually 6.3% with the added protection of a gigantic discount to its issue price.

As I said, DUKH matures on its own in 2073, which is too long for most of us. Therefore, I expect anyone that owns DUKH will not be holding it to maturity. In the prospectus linked above you'll see that there are clauses for the early redemption of DUKH. Starting in January of 2018 Duke can redeem DUKH at any time for the full $25 plus any accrued but unpaid interest. At the present price of just over $20, this means that if Duke were to redeem this issue you'd not only receive a very strong current yield but also a whopping 23% capital gain on your position if it were initiated today. The call price of $25 minus the current price of $20.36 means a potential of $4.64 in capital gains should the issue be called, or roughly 23% upside potential based on the current price. Whether Duke will do this or not is anyone's guess but the large discount to the issue price does provide you with a significant cushion for capital losses.

As with any security there are some risks to owning DUKH. First and foremost is interest rate risk. Since being issued earlier this year DUKH has plummeted to just over $20 on interest rate expectations. While Duke timed the issue of DUKH perfectly that leaves holders of the security in a bad spot because of interest rate movements. This could certainly happen again and while DUKH will continue to pay its quarterly interest payments, an assumption we must make, a spike in interest rates could leave you with significant capital losses. Of course, the opposite could happen and interest rates could come down more, leaving holders of interest-bearing securities with capital gains. You must judge for yourself if interest rates will move up or down and whether or not it is worth the risk but in the current market, DUKH is a strong offering for income.

In addition to that DUKH is a debt instrument and not a preferred stock which means that its distributions are interest payments and not dividends. This is significant for holders in a taxable account as it means that distributions are not eligible for the favorable dividend tax treatment. Rather, they are taxed as ordinary income under most circumstances. Thus, the after-tax yield of DUKH suffers significantly in relation to a comparable preferred stock issue. However, in a retirement account it doesn't matter what the tax rate is; it is something to keep in mind if you would hold DUKH in a taxable account but a non-issue if it is held in a retirement account of some sort.

Overall DUKH offers investors the chance to own a large utility's debt without having to buy it in huge chunks from an illiquid bond exchange. DUKH offers a very strong current yield although the tax treatment of the distributions is unfavorable compared to traditional dividends. The large discount to the issue price offers investors the chance to potentially receive a significant capital gain in the event the issue is called early by Duke and if it isn't, when interest rates move down again at some point in the future, as DUKH's current yield moves down in sympathy, holders could still receive capital gains as DUKH moves up in price. If you can stomach the tax treatment DUKH offers holders a strong current yield from a reliable payer in quarterly installments; you can do much worse in the search for yield than DUKH.

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.

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