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Here’s How to Play Utilities for Dividends

March 04, 2015 – by Richard Band

Are you getting bored with the steady procession of new all-time highs by the headline stock indexes? 

utility stocks

Source: Flickr

Truth be told, it’s anything but a sleepy market. Beneath the placid surface, investors are grappling with a remarkable amount of turbulence — in the utility sector, for example.

Since the Jan. 28 intraday high (only 22 trading days ago), the Dow Jones Utility Average has plunged 11.3%. That’s a steeper drop than the index experienced during the “taper tantrum” of May and June 2013, when interest-sensitive stocks of all kinds plummeted on fears that the Federal Reserve might speed up its timetable for tightening monetary policy.

This time around, as in 2013, the prime culprit behind the selloff in utilities has been a rise in Treasury-bond yields. Since late January, the benchmark 10-year note yield has surged more than 40 basis points (to 2.08% at last glance).

Oddly enough, however, other rate-sensitive assets haven’t been hit nearly as hard as the utes. From its January peak, for instance, the MSCI U.S. REIT index has given up only 6.2%. The Alerian MLP index, helped by a firming in oil prices, has backtracked only 3.9% from its most recent interim high (Feb. 3).

Normally, real estate investment trusts and master limited partnerships fluctuate within a wider range than utility stocks. So, this latest selling wave in the utility sector is out of character — and probably an overreaction.

The good news: The sharp pullback has taken the edge off my concerns that utility shares may have climbed too far too fast. While I’m certainly not going to argue that the utility industry is on the bargain counter, values have improved enough to justify selective buying, especially if you’re an income seeker in or near retirement.

For retirees, there’s a huge risk in buying Treasuries and other high-grade bonds at today’s yields. If inflation picks up from current low levels, your 2% yield on a 10-year T-note could hand you a significant loss of purchasing power (particularly after taxes).

What’s more, history teaches that rising inflation usually begets higher interest rates. Higher rates push down the resale value of existing bonds. Because the T-note’s yield is fixed for the term of the security, you would probably have to take a capital loss if you wanted to exit the holding before maturity.

Utility stocks, by contrast, can sweeten their dividends over time — and most do. Dividend increases give you a hedge against inflation and rising interest rates. For new money, therefore, I definitely prefer utility stocks over most high-grade bonds.

If your taste runs to individual stocks, my first utility pick at the moment continues to be Atlanta-based gas distributor AGL Resources Inc. (NYSE:GAS). You’ll start with a generous 4.1% yield, and I look for AGL Resources to boost its payout over the next five years at a pace comfortably ahead of the cost of living. Buy GAS stock now.

Keep an eye on electric utility Duke Energy Corp (NYSE:DUK), too. Duke Energy is already yielding 4%, but you’ll be able to earn just a tad more if you wait. (Place a limit order with your broker, good until canceled.)

We’re tracking DUK, but if our buy signal gets tripped, we’ll promote Duke to active status to replace Allete Inc (NYSE:ALE). Then we’d hold Allete but not add new money except through dividend reinvestment.

DUK typically issues dividends during the third month of each calendar quarter.

Finally, for the fund investors among us, I recommend Utilities SPDR (ETF) (NYSEARCA:XLU) as an easy, one-stop entrée into the entire electric-and-gas industry. The current yield of XLU is 3.4%. Buy XLU on a dip.

Richard Band’s Profitable Investing advisory service helps retirement savers outperform the market without losing a minute of sleep along the way. His straightforward style and low-risk value approach has won nine Best Financial Advisory awards from the Specialized Information Publishers Foundation.