Hedging Your Income Stocks Portfolio Against Credit and Inflation Risks

By: Roger_Conrad

Income investments come in all shapes and sizes. But all have one thing in common as far as we're concerned: We've got to buy and hold ‘em to get the most out of them. 

Part of that is axiomatic. You can't collect the distributions unless you stick around for them to be paid. Individual bonds are the exception because they accrue interest as long as you hold them. But as far as stocks, Canadian trusts, limited partnerships, income-paying funds, preferred stocks or anything else goes, you've got be in there on the ex-dividend dates or you won't get paid.

Some traders swear by the strategy of dividend capture. That is buying a security before the ex-dividend date and then selling soon afterward. This will get you the dividend, but it will also get you a much larger tax bill. That's because the 15 percent rate on qualified dividends doesn't apply to anything not held at least 90 days.

Ironically, the most important reason income investors need to buy and hold is capital appreciation. A healthy, growing company will increase its dividend over time, and its share price will follow. If you're trading, you won't get that gain unless you're very, very lucky.

Buying and holding, of course, isn't without risks. For income investors, there are basically two: credit risk and inflation risk. 

The former has been on investors' minds this year. And virtually anything perceived as having too much debt—or too unorthodox a capital structure—has taken hits.

There are two ways to protect your portfolio against credit risk. One is by sticking only to high-quality, growing companies and shedding anything where the business fundamentals are weakening. The other is to diversify broadly, both in terms of individual stocks you hold and across market sectors.

When the markets are universally panicked about recession or a credit crunch, big institutional money will pretty much sell off anything that doesn't have the word “Treasury” in it. And that's exactly what happened on the worst days over the summer.

The key in a market like that is to avoid the real blowups, i.e., the companies that are really in trouble. This time around, that was basically financial companies that had gotten in really deep in the mortgage market and/or collateralized debt obligations. As JP MORGAN CHASE'S $5.5 billion writeoff announced today illustrates, there are still some landmines in this area, though that stock is actually up today.

In contrast, damage to most other income investments in recent months was largely because of guilt by association. Limited partnerships (LPs), for example, were walloped by concerns about their debt structures and whether or not they'd be able to access capital markets. Both fears have proven largely groundless, at least for the best quality LPs. As a result, money is starting to flow back in and shares are recovering. 

The lesson: If you avoid the blowups in an environment of elevated credit risk, your losses will be short-lived. In fact, such times are golden opportunities to buy high-quality income stocks cheaply.

THE GREATER RISK

The bottom line is, if you pick your stocks carefully, diversify well, shed holdings that weaken business-wise and are willing to be patient in downturns, you can make your income portfolio pretty much foolproof against credit risk. 

Guarding against inflation risk, however, is a whole other matter. Income-oriented investments are especially vulnerable to inflation because they're valued to a large extent on the basis of yield. Rising inflation pushes market interest rates higher, which makes those yields worth relatively less. As a result, income-oriented investments sell off to a point where yields are again attractive.

During the 1970s, Treasury bonds were among the absolute worst investments to own. Credit risk was zero. 

But every incremental increase in inflation made investors demand a higher yield to compensate for the erosion of principal. And by the time inflation peaked in the late '70s and early '80s, bonds issued at the lower rates of the '60s had lost most of their real value.

We haven't had a real inflation problem in the US since those bad old days. We have, however, had occasional flare-ups that have wreaked havoc on everything from REITs to utilities. 

In each of the past five years, we've had a spring or summer spike in interest rates, as investors have anticipated faster growth and higher inflation. The benchmark 10-year Treasury note yield spiked, and income investments across the board sold off. Each time—including this year—rising rates sowed the seeds of their own reversal, sparking worries about the economy and ultimately sending them lower.


As we move into the fourth quarter, rates are down and credit worries are receding. As a result, income investments are starting to recover their summer losses. That rally should continue throughout the fourth quarter. Utility stocks, for example, have had a positive fourth quarter in 35 of the last 40 years.

After that, however, the future gets considerably cloudier. With the Federal Reserve apparently willing to do whatever it takes to avoid recession, credit risk is no longer the primary concern. Rather, it's inflation. And the more money the Fed and other world central banks pour into the system now to bail out the likes of JP Morgan, the greater the risk.

One way income investors can protect themselves against inflation is healthy growth. Not even companies that can grow dividends reliably and robustly have historically been able to hold their share value in the face of rapid inflation. But they do a credible job with moderate inflation, if for no other reason than investors need to get their income from somewhere.

How bad can inflation get this time is the $1 million question. And as is always the case with market economics, that's impossible to forecast.

What we do know, however, is there are investments that pay moderate income and actually do very well in inflationary environments. By adding them to already diversified portfolios, we can cut the inflation risk to our overall portfolios.

What I'm talking about are metals and other vital resources. Over the past five years or so, many of the raw commodities—from copper to zinc—have doubled and tripled in value. The primary reason is global growth.

Not since the '70s has the world seen such robust, synchronized economic growth. And unlike then, the US isn't the only driver of growth this time around. 

We're still the most important economy. But China, Japan, Europe, India and the Middle East are also driving things. That makes this growth wave a lot more durable than the last one. In other words, a US recession would no doubt slow things down, but it wouldn't derail global growth as it did in the early '80s.

Metals and other raw commodities are the essential fuel for global growth. And the faster and more universal growth is, the greater the strain on supplies. Already, we've seen Russia plant its flag on the North Pole, while China and Europe are snuggling up to African dictators and the regime in Iran. And that's only the beginning, as competition for scarce resources grows.

Eventually, every commodity cycle ends. Ever-rising prices induce consumers to change their habits and develop alternatives, even as they incentivize new discoveries. The process, however, can take years and even decades before the supply/demand balance shifts back in favor of consumers, and it's never entirely painless.

One of the hallmarks of a top in a commodity cycle is breathless speculation that supplies are truly running out. I'm not hearing any of that now in the financial media. 

In fact, the buzz is largely about how the commodity bull has reached unsustainable levels and that its days are numbered. This is in stark contrast to what's happening in the market place, and the disconnect likely points to a lot more ahead.

Commodities and vital resources are good inflation hedges for one major reason: They represent hard value. Gold, for example, has been a global store of value for millennia. When US inflation undermines the value of paper money, gold holds its own—mainly by surging in US dollar terms.

The best way to play a boom in commodities and vital resources is to buy stocks of the companies that produce them. For one thing, gains are leveraged. For example, a company producing copper at a total cost of $1 a pound will see its earnings double if the metal moves from $2 a pound to $3 a pound—a 50 percent gain in the metal itself. And good companies are always growing, providing a rising base of earnings.

I've already been talking about high-yielding energy bets like Canadian trusts, Super Oils and combination utility/producers for some time. We've seen some staggering profits in these over the past five years or so. And until we see the factors that ended the '70s energy bull market in abundance—greater conservation, switching to alternatives (not biofuels), new conventional reserve discoveries (not from oil sands or extreme deepwater drilling) and a global recession—we're going to see a lot more gains.

The takeover offer for Canadian trust PRIMEWEST ENERGY TRUST by the ABU DHABI NATIONAL ENERGY CO—which was at nearly a 40 percent premium to the pre-deal price—is a pretty clear value alert for that sector. And whether it means takeover for the likes of other strong trusts like Enerplus Resources or Penn West Energy Trust or not, it does add up to big gains ahead for the best trusts, in addition to their high distributions.

Energy is only one resource that offers income investors an inflation hedge. Over the next several months, I'll be talking more about others in a wide range of other vital resource areas and their place in a balanced income portfolio.

I'd also like to call your attention to a new service co-edited by myself and Yiannis Mostrous, Vital Resource Investor. Yiannis and his The Silk Road Investor—which focuses on high-growth Asian markets—have been frequently quoted in Utility & Income.

Basically, we're pooling our talents—along with those of 30-year commodities trading veteran and Commodity Trends editor George Kleinman—to provide a premium advisory on a full range of vital resource stocks from four major sectors: base/industrial metals, precious metals, agricultural resources/water and other raw materials like steel. 

Some of our picks feature high yields; some won't be paying much but will offer more in the way of growth. All of our recommendations, however, will be strong companies poised for robust growth as long as this resource boom lasts, which should be years. Just as important, all will have the sustainability to outlast the inevitable ups and downs that accompany resource bull markets. A link for more information is provided here .

COAL'S STEALTH BOOM

One reason I'm convinced this energy bull market has legs is the opposition to using domestic supplies, particularly coal. Coal is the source of more than half of US electricity production, the majority from plants that have been around a generation or more. It's also the source of a large chunk of US carbon-dioxide (CO2) production, which is blamed for global warming.

Under the Bush administration, federal energy policy has been basically pro-coal. The focus has been on cleaning up emissions from existing plants and switching to more efficient ones that emit little or no particulate matter, mercury or the gases that cause acid rain—sulphur oxide (SOX) and nitrogen oxide (NOX).

The administration's views have basically reflected those of industry: That coal use is vital to keeping America's grid running and to meet the 41 percent growth in electricity sales by 2030 that's projected by the Energy Information Administration. There's also increasing concern that the older coal plants are wearing down and that the current strategy of keeping them running by just replacing broken parts is only going to work so much longer.

Coal use is also popular because it's so much cheaper than burning natural gas. After nearly a decade of wrenching adjustment and owner bankruptcies, the 90 gigawatts of gas-fired plants built during the late '90s have been absorbed into the grid. And because it's mostly under the ownership of strong utilities, it's being operated economically, despite the fact that gas remains three times as expensive as when these plants were originally planned. 

It's far from a baseload fuel, however, and the plants mostly run in peak season when power prices rise enough to fatten profit margins.

Over the past couple years, however, the tide has been turning against coal on the state regulatory and legislative level. The key catalyst is growing worries about global warming caused by CO2 emissions, of which coal-fired power is the single-largest contributor. 

Coal plant opponents were emboldened earlier this year, as the private capital consortium buying TXU CORP promised environmentalists it would cancel five of eight coal-fired plants the utility was planning to build. Its push has picked up steam on the local level in several other states as well, including Florida, where TECO ENERGY dropped plans this week to build a $2 billion integrated gas combined cycle (IGCC) plant.

IGCC represents a revolution in coal plant technology. Basically, coal is cleaned by turning it into gas, which is then burned to generate electricity. The result is a dramatic decrease in emissions of all varieties and radical increase in efficiency. However, because CO2 is still a by-product, IGCC is virulently opposed.

Even if Democrats don't succeed in winning back the White House, carbon regulation on the federal level looks all but inevitable. This could involve an actual carbon tax or the imposition of a cap-and-trade regime, which would force coal burners to buy credits to emit CO2 until they can mitigate emissions some other way, such as carbon capture. 

Meanwhile, we're certain to see considerable activity on the state level to squelch plans for new plants nationwide.

Ironically, despite these odds, there are still some 21 plants of 200 MW or greater capacity under construction now. And there are at least 15 more that either have all their permits or are moving through the final stages of getting them, which are on schedule for commercial startup within five years, according to industry data provider Platts.

That's an aggregate capacity of some 22 gigawatts. Moreover, there are many more plants proposed whose developers are in the process of lining up funding and permitting but aren't yet far enough along to be put on the five year startup list.

Cost is a big reason coal is still popular. According to Platts, even factoring in an effective carbon tax—or cost of credits—of $7 to $10 per short ton of carbon, using coal for baseload power still compares extremely well with chief rival natural gas at $7 per million British thermal units (MMBtus). And according the consulting company ICF International, it would take an effective tax of $25 per short ton of coal to make gas-fired power competitive with it at $8 per MMBtus.

Moreover, even 22 gigawatts of new coal capacity won't come close to the expected growth in power demand, even at the Energy Information Association's currently conservative projection of 1.5 to 2 percent growth to 2030. And that's not counting the aging coal plants that are likely to be shut down, as rising carbon costs and the sheer effect of aging makes them uneconomic to run.

With a new generation of nuclear plants a decade away from production even in a best case—and even assuming maximum projections for wind, solar, geothermal and tidal power, and conservation—that still leaves a big gap. As a result, I'm inclined to agree with DUKE ENERGY CEO Jim Rogers, who forecasted a “dash for gas” at the Edison Electric Institute annual convention this year.

As we saw in the '90s, natural gas-fired plants can be constructed far more quickly than baseload coal or nuclear. And the incremental demand is bound to budge gas prices off their current levels. That will enrich now-struggling natural gas producers but will also make gas-fired power that much less competitive with coal.

Small wonder, then, that coal-fired power in the US is still alive and very well. And when carbon capture and other CO2 ameliorating technologies do become economic—at least a decade hence by even the most optimistic estimates—the new generation of plants will be more competitive still.

Of course, it's equally likely that some of the plants now under construction or in advanced stages of permitting will be killed off before they start producing. And the odds of that will grow as global warming fears rise and stir increasing opposition. 

For a regulated utility, having a plant nixed in advanced stages of construction is a severe financial hardship. The good news is the burdens are widely dispersed, with 19 developers involved in the 21 plants slated for startup by 2010. And their ranks include regulated US utilities like XCEL ENERGY, foreign giants like Germany's E.ON, cooperatives like SANTEE COOPER and unregulated developers like DYNEGY. 

Even if the country passed an immediate moratorium on new coal plants, only two utilities would be in danger of a major financial drubbing: WISCONSIN ENERGY CORP and TXU, which later this year should be acquired by a private-capital consortium led by Kohlberg Kravis Roberts.

Moreover, such a draconian step would be fiercely opposed and easy to filibuster in the US Senate, even if the Democrats add to their majority in 2008. The primary reason is this is more a regional issue than a party issue, and there simply aren't enough “aye” votes from Northeastern and West Coast states in the upper chamber to overcome the “nays” from the Southeast and Midwest, which are heavily reliant on coal.

As I've pointed out in prior U&I issues, how well utilities are able to cope with CO2 regulation basically depends on their regulators. In this, the South and Midwest are actually advantaged, as places where historical cooperation has prevailed. 

Much is uncertain, as is always the case with a politically charged issue like global warming. At this point, my view is most utilities will be able to absorb added costs of coal generation without much financial hardship. But this is one situation that will bear a lot of watching in coming years.

What's more certain, however, is that coal demand will remain strong in coming years; there's just no alternative. Meanwhile, we're almost surely in for higher natural gas prices, as more of it is burned to generate electricity. 

Dividend-paying natural gas and coal stocks are consequently great ways to hedge your portfolio against future inflation. I like the trusts named above. Another one to look into: PENN VIRGINIA RESOURCES LP, which owns royalty interests on coal mining properties as well as midstream gas assets.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

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