Investing in Utility Stocks

Those who read my post from early January, "What's Working in this Market Correction", will know I favor utility stocks in the current market.  In fact, the utility ETF, XLU rose from 43 on January 4 to 50 on March 28, or a gain of 16% in 12 weeks.  It's since backed off, now trading at 48.  I'll explain why in a moment.  First, why I like utility stocks and what their performance this year says about the economy.

XLU

Utility stocks essentially trade like bonds.  Known for consistent and high dividends, investors buy utility stocks as they would fixed income securities, for their predictable level of dividend payments.  The dividend yield, or the relationship between the annual dividend and the stock price, is often equated to a bond yield for more traditional fixed income securities.  Utility stocks are not pure dividend plays, though, and we'll get to this issue in a moment, as well.

Trading like bonds, of course, means that price and yield vary inversely.  As interest rates rise, the price of bonds and utility stocks decline.  As rates decline, utility stocks tend to appreciate. Over the past two months, since the lows of the stock market in February, stocks have rallied following a risk on momentum trade.  Bonds have weakened.  The US 10-year has traded as low as 1.63% and as high as a 1.97% over this period.  

If this risk on rally that has been leading momentum into the least favored sectors of the market is about to turn once again, however, the focus will shift back to the continued weakness in GDP, consumer spending, capital investment, durable goods orders, commodity prices and corporate earnings.  This perceived weakness will damage stocks, but boost fixed income securities that rally in the face of low growth and inflation.

This being said, while factors favor utility stocks, I don't prefer the ETF alternatives, and here's why.  Utility stocks largely trade like bonds, but not entirely.  Their values also swing based upon forecasted revenue on energy sales to their customer base.  In some regions of the country, that customer base can be heavily industrial, for instance Texas, Oklahoma and much of the mid-west.  If the economy is in fact slowing, industries in these regions will likely reduce their consumption of power, impacting utility revenues.

Residential demand for power, on the other hand, is highly stable and far less impacted by economic cycles.  For this reason, better opportunities present themselves in utilities with higher residential customer profiles, than what might be achievable with the XLU.  A few large utilities that fit this profile and should be considered are Duke (DUK) with 6.2 million of its total customer base of 7.2 million being residential, Southern (S0) and Exelon (EXC).

San Bernardino's Pension Fiasco

New details emerged this week on the City of San Bernardino's bankruptcy recovery plan. Reuters reported a proposed settlement with two of the creditors of the city's 2005 pension obligation bonds. That plan calls for bondholders to write off as much as 60%, or $30 million of their original $50 million investment. 

The bonds in question were originally issued by the City back in 2005 to help shore up the city's struggling public employee pension fund, held by the California Public Employee Retirement System, or CalPERS.  Unable to come up with the funds to fulfill its commitment to retirees, the city turned to the public bond markets, selling bonds and using the proceeds to pay CalPERS. In being granted authorization under law to issue the pension bonds in 2005, the city obtained a court ruling confirming that the city wasn't issuing new debt, per se, but rather refinancing debt it owed to the CalPERS pension fund.

By July 2012, though, soon after it filed for bankruptcy, the city failed to make required semi-annual payments on the bonds, throwing the bonds into default.  Interestingly, in its bankruptcy filing, the city blamed the high costs of its fire and police labor contracts, including pensions as the main issue forcing the bankruptcy filing. Now in bankruptcy, the city failed to make payments on the bonds funding that pension liability, as well.

The two principal holders/guarantors of the bonds sued the city soon thereafter, arguing that the bonds should be paid on an equal basis with the city's continuing obligations to fund its pension account at CalPERS.  But in the end, the powerful, $300 billion CalPERS prevailed in court. In May 2015, a bankruptcy judge threw out the bondholder suit, allowing the city to proceed with its plan to make pension payments to retirees in full, while forcing bondholders to suffer significant losses on their loan to the city.

Now let's step back here a moment and take a look at what has actually transpired.  The city, through negotiation with its employee unions, had agreed to make a certain level of lifetime pension payments to retired city employees. Unable to come up with the funds from tax revenues and other sources to do so, the city borrowed $50 million from investors. It deposited these funds with CalPERS, the pension trustee, on the city's behalf.  

Now, in cramming down a loss of $30 million (or 60%) to bondholders, the city is arguing that it doesn't have the funds to make full repayment. However, it actually does. The full $50 million that the city borrowed, plus interest, remains on deposit in the city's pension account with CalPERS. So, in effect, what has happened is that the city effectively stole $30 million from investors (the difference between the original borrowing and the amount to be repaid) using the money to make whole on its pension commitment to employees.

Now, here is where this gets truly galling. As reported in our blog from May 2015, a study of salaries of the 120 highest paid firefighters in San Bernardino reported by Bloomberg shows the top one-third drawing an average salary of $190,000 per year; the next third $166,000 (this is in a city where the median household income is $52,112 per year). In retirement, as early as age 50, these firefighters may be eligible for annual pensions of up to $171,000 per year, an obligation the city will need to pay for many years to come. This might, in part, explain the types of management decisions that led up to the city's bankruptcy and its nearly unconscionable deal with its bondholders.

Much more on the public pension and retirement crisis can be found in my new book: Up In Smoke: How the Retirement Crisis Shattered the American Dream, available on Amazon.com.