Why Utilities Really Trump Treasuries

I recently read an article on Forbes’ website that attempted to help income investors compare the merits of utility stocks and U.S. Treasury bonds.

On the bad news side, the column noted that the yields on both utility shares and 10-year Treasuries are down about 50% since the beginning of 1995. Ouch!

Even more hurtful to my dividend-loving heart was this assertion:

“But with a few short-lived exceptions, the 10-year Treasury bond has delivered higher yields than the average utility stock. Since 1995, the T-bond has averaged a 5.2% yield, while the average utility has yielded 4.2.”

But wait, obviously there are “short-lived exceptions,” right? That means savvy investors do have opportunities to lock-in above-average yields?

Yes and yes. In fact, right now is one of those rare gifts. As the Forbes article pointed out, this is the first time since 2003 that the average utility stock (as measured by the S&P 1500 Utility index) has yielded more than 10-year Treasuries.

What the article didn’t point out is that …

There Is Another, Even More Compelling
Reason to Choose Utilities over Treasuries:
There’s No Ceiling on Your Effective Yield!

Let’s say your friend buys a 10-year Treasury today. He is now virtually guaranteed an annual yield of 3.7%.

Never mind that you can easily find utilities with much higher yields right now.To keep our example simple, let’s just say you opt to buy a utility that yields the very same 3.7%.

In other words, you buy a $10 stock that pays an annual dividend of $0.37.

Your friend is quick to point out that there’s no guarantee on that yield … and he’s right. However, you picked a company that has been paying a dividend consistently for decades, even increasing it by roughly 10% every year.

Now pretend that ten years have gone by:

Your friend’s 10-year Treasury just handed him his last payment, which was good for an annual yield of … you guessed it, 3.7%! Oh, and unfortunately he now has to figure out where to reinvest his principal. I sure hope rates are good in 2018!

Meanwhile, your utility just gave you an annual yield of 9.6% based on your initial purchase price!

How can that be?

Well, you bought the stock at $10 and its annual dividend was $0.37 a share.

But every year since, the dividend payment increased 10%. Check out my table to see how the dividend rose each year!

End result: Ten years later, you’re receiving an annual payment of $0.96 a share. Divide that $0.96 a share by your original purchase price of $10 and … a whopping effective yield of 9.6%!

Even better, you’re likely to get another pay raise every year going forward, no matter what prevailing interest rates look like! And as long as the company keeps boosting its dividend, and you keep holding the shares, there’s no limit to how high your effective yield can go.

It’s crucial that income investors understand this concept, known as “yield on cost.” After all, it highlights the hidden value of buying and holding stocks with consistently rising dividends. And it is another way of looking at the yields currently available to you.

One other thing …

You’d Probably Be Sitting On
Some Capital Appreciation, Too!

Look, I don’t think income investors get much benefit from trying to trade dividend-paying stocks. Instead, I think they’re best served by buying and holding companies that consistently raise their payments.

But I do want to point out that it’s very reasonable to expect dividend stocks to increase in value over time, too. By their nature, these are profitable companies that are growing at fairly predictable rates. So, naturally, investors will bid the share prices up over time.

Sometimes the gains can be especially good, too! Heck, utilities are a great example.

In the last four years, they have been posting very strong capital appreciation. Take a look at my chart. As you can see, the Standard & Poor’s utility index has risen solidly in each of the last four years.

So far in 2008, utilities have been taking a bit of a breather. But given the fact that these companies tend to see steady demand during rough economic patches, and given their relatively big, stable yields, I continue to think they’re a smart addition to long-term income portfolios. Any long-term capital gains are just icing on the cake.

Best wishes,

Nilus

P.S. I’m currently recommending three U.S.-based utilities, and one Chinese power company, in my Dividend Superstars newsletter. If you want to learn all about those firms, as well as my other favorite income-producing investments, subscribe now. The cost is just $39 a year, and if you sign up today I’ll rush you a series of valuable bonus reports, too! Click here for all the details.

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