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Is there a second life for high-yield stocks?
Since interest rates started climbing last spring, many stocks with high dividend yields have struggled to keep up with the market. Higher rates pressure these stocks, partly because they make bonds and other investments more competitive. And some of the biggest laggards have been utilities, telecom firms and energy pipelines — infrastructure companies that could face the most pressure if rates rise further.
Yet for income investors, these stocks may be worth considering, according to some fund managers and other investing experts.
Many utilities now yield about 4% while some telecom and pipeline stocks yield north of 5%. Those yields beat the 2% yield of the S&P 500 and the average 3.2% yield of U.S. corporate bonds, whose prices would decline if interest rates rise.
Utilities and other infrastructure stocks also tend to be defensive: They typically lose less when the economy and financial markets stumble. "In theory you have less volatility with utilities and more downside protection because of their dividend yield," says Douglas Simmons, manager of the Fidelity Select Utilities Portfolio (FSUTX).
Those characteristics could make the stocks appealing to investors who want to emphasize preserving capital more than growth. Indeed, even if interest rates rise, some fund managers think these stocks could deliver attractive returns through a combination of dividend income and modest price gains.
"Rising interest rates are a big deal for these stocks but they're not the only factor," says Tim Porter, a New Jersey-based money manager with Reaves Asset Management, which specializes in infrastructure investing.
One key is to focus on companies growing both profits and dividends. Stocks with rising dividends tend to outperform non-dividend payers in rising-rate climates, according to research from Fidelity. The stocks also may fare better than investment-grade bonds, which have fixed-income payments that become less valuable as market yields climb, pressuring bond prices.
Rising rates also tend to coincide with a stronger economy, benefiting these companies. Electric utilities, gas distributors and pipeline operators should see stronger demand as the economy strengthens. That should help them grow earnings and return more cash to shareholders through higher dividends, says Porter.
Granted, rising rates tend to have a dampening effect on the stocks. Most are heavily indebted and would face higher borrowing costs if rates were to rise, hurting their profitability. Utilities are also heavily regulated and could face pressure to cut prices they charge consumers for electricity.
Still, some money managers see several factors that could help offset those pressures.
Companies involved in natural gas distribution, processing and delivery look well-positioned to grow, says Fidelity's Simmons. Natural gas is cheap and abundant thanks to the boom in domestic shale drilling, he notes. Demand for natural gas from manufacturers, electricity generators and consumers is growing — and they all need utilities to process and deliver the commodity.
Utility funds with above-average returns include the Prudential Jennison Utility Fund (PCUFX), MFS Utilities Fund (MMUCX) and Fidelity Telecom and Utilities Fund (FIUIX). All three funds have beaten the category average over the last three and five years, according to Morningstar.
Key risks: Utility funds could slump if interest rates rise sharply.
Individual stocks carry more risk than funds but may offer more upside. Duke Energy (DUK) and FirstEnergy (FE) are two to consider, according to Andrew Rand, managing director with Rand & Associates, a financial adviser in San Francisco, who owns the stocks for his clients.
Based in Charlotte, N.C., Duke is the country's largest electric utility and has raised its dividend 3.3% a year, on average, over the last five years. Ohio-based FirstEnergy sports a 6% yield and has good potential for dividend growth, Rand says. Further, both companies should manage to grow profits despite higher interest rates.
"It wasn't long ago that interest rates were above 4%," Rand says. "It'll be a drag when rates go up, but these companies can still operate profitably."
Key risks: The stocks are sensitive to interest rates and could fall if rates keep rising.
Dominion Resources (D) is another utility that may benefit from the shale gas boom.
Based in Richmond, Va., Dominion is an electric utility with a gas pipeline business centered around the Marcellus and Utica shale regions — two areas with thriving gas production. The company is developing a liquefied natural gas export terminal in Maryland that could also lift profits.
Yielding 3.4%, the stock is one of the "better growth stories" in the utility space, Barclays analyst Daniel Ford wrote in recent research note.
Also worth considering is ITC Holdings (ITC). Based in Novi, Mich., ITC is one of the nation's largest owners of power transmission lines. Federal regulators want transmission companies to upgrade the national power grid, and the government is essentially guaranteeing a rate of return on the infrastructure investment.
In addition, ITC is trying to buy transmission assets from power producer Entergy (ETR), a move that could boost its earnings, according to Morningstar analyst Charles Fishman. Even without that deal, he expects ITC to grow profits 12% a year for the next five years, supporting a higher dividend and stock price.
Key risks: Both companies face regulatory risks, including lower base rates and returns on their utility investments. ITC's stock could slump if the deal with Entergy isn't approved.
With U.S. oil-and-gas production rising, pipelines and storage facilities should benefit, says the San Francisco adviser Rand. Most are organized as master limited partnerships (MLPs), which tend to have stable cash flows and pay out the bulk of their net income as distributions to shareholders.
Rand invests through the Alerian MLP ETF (AMLP), an ETF that tracks 26 MLPs. It currently yields 6.1% and has an annual expense ratio of 0.85%.
Key risks: MLPs are sensitive to interest rates and commodities prices. The ETF has trailed its benchmark index since inception, partly because of taxation.
Some telecom stocks also look compelling, says the portfolio manager Porter. "We're not talking about high-growth businesses," he says, "but they're very stable and have attractive yields."
Stocks to consider include AT&T (T), Time Warner Cable (TWC) and Canada's BCE (BCE) and Telus (TU). The stocks yield from 2% to 5% and should have ample cash-flows to boost their dividends, according to the fund managers we interviewed.
Key risks: Telecom companies carry lots of debt and the stocks could slump if their borrowing costs rise sharply.
|Fund name||Dividend yield||Expense ratio|
|Alerian MLP ETF (AMLP)||6.1%||0.85%|
|Fidelity Telecom and Utilities Fund (FIUIX)||1.7%||0.83%|
|MFS Utilities Fund (MMUCX)||2.2%||1.77%|
|Prudential Jennison Utility Fund (PCUFX)||1.3%||1.57%|
|Company name||Dividend yield||P/E ratio|
|Dominion Resources (D)||3.4%||19.9|
|Duke Energy (DUK)||4.4%||16.6|
|ITC Holdings (ITC)||1.8%||19.3|
|Time Warner Cable (TWC)||2.2%||18.2|
Source: Thomson Reuters Datastream | P/E ratios based on estimated 2013 earnings
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.
Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.