Here’s Where I’m Hunting for Safe Stocks With High Yields
Interest rates have jumped on stronger economic growth in the United States and abroad causing prices for rate-sensitive investments to plunge. Traditionally low-risk investments like the iShares 20+ Year Treasury Bond Fund (NYSE: TLT) and the Utilities Select Sector SPDR ETF (NYSE: XLU) have booked large losses that will likely extend when the Fed finally starts to lift rates.
But utilities still play a vital role for many investors that need consistent income and can be a blessing when the general market tumbles.
Using one of my favorite options strategies for reducing risk can provide extra income for those investors while maintaining a position in the sector for longer-term portfolio diversification.
Taper Tantrum, Round 4 — Rates Surge
Volatility due to rapidly rising interest rates is nothing new for investors in utility stocks. Rates on the 10-year Treasury jumped 1.3% in 2013 when the Federal Reserve announced that it would begin tapering its $70 billion monthly bond purchases. Shares of the SPDR utility fund dropped 10.2% in the four months leading up to September of that year. Markets have seen two other periods of rate hike fears since then. The first was in late 2014 when the Fed ended its third round of quantitative easing. The other came after this year’s January Fed meeting when the central bank noted that rates could be increased as early as the summer.
While a rate hike isn’t expected until September at the earliest, rates have again jumped higher on stronger economic data in Europe and continued improvement in the U.S. employment picture. The rate on Treasuries has increased 0.32 percentage points since April 17, leading to a 8.8% loss on the iShares Treasury fund and losses of 3.5% on the SPDR utility fund.
2 Best-of-Breed Utilities
Against broad losses on rate-sensitive investments, two utility companies stand out for their relative outperformance. The table below compares returns from the three recent periods of rapidly increasing rates and the current period. Two stocks have outperformed the SPDR utility fund every time, with an equal-weight investment in the two outperforming the fund by a cumulative 22% over all four periods.
NextEra Energy (NYSE: NEE) provides regulated utility service to 4.5 million customers in Florida (60% of operating earnings) and non-regulated services throughout the United States and Canada. The company recently received regulatory approval for its merger with Hawaiian Electric Industries (NYSE: HE), which is expected to close later this year. The company settled a rate case with the Florida regulator that allows $1 billion in permitted revenue increases and a 10.5% return on equity through 2016. The company is also taking advantage of federal tax credits to build out its renewables business, which should offer revenue growth in the future.
The company spun off NextEra Energy Partners (NYSE: NEP) in June 2014 to take advantage of tax benefits to the MLP structure. NextEra still owns 80% of the limited partner and acts as the general partner of the company, meaning it could receive significant incentive distributions that could boost cash flow in the years to come. NextEra Energy shares trade for 16.4 times trailing earnings and also pay a dividend that yields 3.1%.
NRG Energy (NYSE: NRG) is the largest power producer in the United States, with 49 gigawatts of coal, gas, nuclear and oil power generation capacity in Texas, California and through the mid-Atlantic region. The company took advantage of the 2009 crash to acquire retail supplier Reliant Energy and further diversify its product portfolio. That diversification has helped it smooth earnings during volatile commodity prices. The shares pay a dividend yield of 2.4% and trade for 74 times trailing earnings.
Using Call Options to Reduce Risk and Generate Income
Investors are optimistic about the future outlook for NRG Energy and are willing to pay for volatile earnings growth. While the shares have done well during the past three rate crises, I prefer shares of NextEra on valuation and potential for the merger to support investor sentiment through this year. Over the longer term, incentive distributions from NEP could significantly add to NEE cash flows.
Despite my optimism for shares of NextEra, rising rates could limit share price growth over the next year. Fortunately, I can use a covered call strategy to lower my cost basis and provide cash flow on the position.
With NEE trading at $99.24 per share at the time of this writing, we can buy 100 shares and simultaneously sell NEE Sep 100 Calls, which are trading around $3.15 ($315 per contract) for a net cost of $96.09 per share. Our cost basis discount of 3.2% on the current price is not exceptionally high but still allows for some weakness on any further increases in interest rates.
If NEE closes above the $100 strike price at expiration on Sept. 18, our shares will be sold for that price. In this case, we will make $3.91 per share in capital gains for a profit of 4.1% in three months. That amounts to an annualized 15.5% gain on a sector that may struggle to post a positive return this year. I like the trade as long as you can get in for a net cost of $97.05, which still leaves you with a gain of 3% and a 2.2% discount to current prices.
Beyond the potential for return, the strategy allows me to keep my exposure to utilities with some downside protection. The coming merger with Hawaiian Electric should help to support the shares this year while cash flows from the NEP limited partner could drive shareholder returns in coming years.
If the NEE’s price is below $100 when the option expires, we keep the shares and the option premium. We’ll then have the opportunity to sell another call to generate more income and lower our cost basis further.
Not selling covered calls each month on at least some of the stocks you own is like passing up free money. One of my colleagues likens it to owning a rental property and not collecting rent. You wouldn’t do that, so why would you pass up on the opportunity to generate income on the stocks in your portfolio?
Some traders are using covered calls to earn an extra 9%-plus monthly on the stocks they own. If you want to learn how you can get started doing that today, follow this link.