Bargains in Bondland

06/11/2004 12:00 am EST

Focus:

Richard Band

Editor, Profitable Investing

"For the income seekers among us, I’ve got a smorgasbord of high-yielding ideas," says Richard Band, editor of Profitable Investing, who notes, "Indeed, bargains are back on bondland." Here are some of his best bets among bonds funds and dividend-paying stocks.

"While this isn’t a ‘back up the truck, grab all you can’ buy signal for bonds of every sort and description (that glorious day will probably come during the second half of 2004, after one or two rate hikes by the Federal Reserve), I’m warming to longer-maturity bonds again, for the first time in many months. What has changed? For one thing, bond yields have gone up—a welcome development if you’ve got new money to invest. However, I’m beginning to think that interest rates may not shoot up so steeply this time as they did in past cycles (1994 or 1999, for example), as the deflationary undertow in today’s economy is much stronger. Big-time inflation isn’t in the cards.

"I see another reason to suspect that any run-up in bond yields is likely to be muted. Every Dick and Jane in the financial community seems worried about a rate spike. To me, that means the bulk of the move (at least in the bond market) has probably occurred already. If you’re an income investor hungry for higher yields, here are two possibilities that allow you to buy bonds (or bond equivalents) for less than 100 cents on the dollar: Thanks to the run-up in bond yields, a number of closed-end bond and preferred funds are paying as much as 8% or even 9%. If, as I suspect, the Fed ends up tightening credit a lot less than Wall Street fears, these vehicles could deliver fat capital gains, too.

"Alliance World Dollar Government Fund II (AWF NYSE) is my racier pick. Prospects of a Fed rate hike have struck terror into the hearts of traders in emerging-market debt. As a result, the share price of this closed-end fund has plunged to a steep 14% discount to net asset value. In other words, you can buy $1 worth of government bonds from some of the most creditworthy emerging nations of the world for only 86 cents. The fund’s yield has also soared to 8.7%. I think the concerns are vastly overstated. Countries like Mexico, Russia, and Brazil have done a remarkable job of cleaning up their finances since the crisis-ridden 1990s. (Russia’s ratio of government debt to GDP has shrunk to just 26%—less than half the comparable figure for the United States and down from 93% in 1999.) Buy AWF at $11 or less.

"Preferred stocks behave like bond substitutes—and lately, several closed-end preferred funds in the John Hancock family have fallen to significant discounts to net asset value. John Hancock Preferred Income Fund (HPI NYSE) was recently quoted at a plump 6% discount with a current yield of 9.6%. How can HPI afford to pay a stratospheric 9.6% on a portfolio of investment-grade preferreds? The discount helps, but you should also be aware that the fund borrows money (at short-term rates) to enlarge its holdings. Thus, as lending rates go up, the fund may have to pare its monthly dividend somewhat. Still, I don’t expect a drastic cut in the payout—and, in the meantime, you’re earning considerably more than if you bought similar quality preferred stocks on your own. Buy HPI at $23 or less.

"We are also adding a few stocks to our ‘Incredible Dividend Machine’ portfolio. Folks who live for capital gains alone start to feel mighty antsy when the stock market flounders. Not so for those of us who are pocketing dividends. Dividends whisper in your ear, over and over again, that you own a successful business throwing off real cash. Money is coming back to you—the most basic definition of return. Our selection process for our Incredible Dividend Machine is rigorous. Only companies with healthy balance sheets, solid earnings prospects and safe, sustainable dividends make the grade. Here are the newcomers to the Machine:

"FPL Group (FPL NYSE) earns four-fifths of its profits from steadily growing, regulated electricity sales in the state of Florida. We shifted FPL to hold status when the stock got too pricey, but now it’s back in a reasonable buying range. FPL is rolling in cash. With only 49% of its estimated 2004 profits going out the door as dividends, the company has plenty of room to lift the payout. Shareholders got an inflation-beating 3.3% hike this year (the tenth annual increase in a row), and I expect a similar—or possibly even greater—boost in 2005. Buy at $63 or less.

"KeySpan Corp. (KSE NYSE) is a natural gas utility serving 2.5 million customers in New England. The company also generates electricity (it’s the largest investor-owned power producer in New York State); operates gas pipelines and storage facilities; and drills for oil and gas. What interests me about KSE right now is that the company is shedding some of its fringe assets to reduce debt and focus on the utility business. That policy suits me just fine, since it makes the dividend (current yield: 5.1%) more secure. KSE hasn’t sweetened its dividend for the past couple of years, but the low payout ratio makes me think an increase is coming within the next 12 months. Buy below $36.

"Regions Financial (RF NYSE) is an amazing bank that has boosted its dividend 33 years in a row. With growth like that, you don’t need to fret about the Dow’s short-term swoons and spurts. Based in Alabama, this banking chain is in the process of swallowing up Union Planters, a Tennessee bank. It’s a good marriage, strengthening both partners. What’s more, RF didn’t overpay. The merger will immediately add to RF’s earnings. No dilution. That’s how a stockholder-friendly management operates. Buy below $37."

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