Income Security Recommendations

BondsOnline Advisor –November 2007

By Stephen Taub

The BondsOnline Advisor strives to present you with income investment insights from analysts throughout the United States. Bonds, preferred stocks, real estate investment trusts, or energy master limited partnerships can be a part of a successful income portfolio – and BondsOnline and PreferredsOnline provide the “Income Investor Tools” to keep you informed.

Strategy/Citi Investment Research

Citi is still bullish on the stock market. Reacting to the market’s recent roller-coaster ride and one-day selloffs, Citi recently reassured its clients that its sentiment model continues to point to gains over the next 12 months in the Russell 2000, adding, that valuations appear reasonable. “We suspect that volatility will continue as third quarter earnings progress,” it added.

However, it conceded that except for another possible Fed rate cut, it has difficulty identifying potential catalysts. Even so, it warned investor not to ignore history.

And what does history tell the investment bank? Within the fourth quarter, December has typically been the most reliable month for gains in the Russell 2000 and S&P 400. That said, in recent years December has become a less reliable “rally month.”

And even though the Russell 2000 has risen in 79% of Decembers since 1979, it has only experienced positive returns in Decembers in three of the past six years. Rather, the bulk of fourth quarter gains has come in October and November, it noted.

This year, November appears to Citi to be the make-or-break month for the fourth quarter rally, given the lackluster October. “Given looming recession concerns, investors may also move to the sidelines in December once again, which could cut short any fourth quarter rally in small caps,” it added.

Keep in mind that since 1979, there have only been eight years in which small caps have failed to rally in the fourth quarter, mostly during the 1980s.

Strategy/Lehman

Lehman recently told clients its sentiment signals are giving strong buy signals. “The flow-based signals indicate depressed sentiment, which is bullish for equities,” it explained.

Its short-term positioning signal based on CFTC data is also comfortably in buy territory, it added.

Lehman also looks at certain sentiment measures. For example, the AAII bulls/bears (American Association of Individual Investors) sentiment signal is currently close to neutral, Lehman noted. It measures sentiment among smaller investors.

The bank also said put/call ratios are close to neutral. “These signals have been much more effective at identifying buying opportunities than selling opportunities,” it explained.

Healthcare REITs/Stifel Nicolaus

Stifel recently expressed surprise that the market’s overall turmoil dragged down the health care REITs, which it perceived to be among the more stable, defensive issues. It noted the group offers a 5.8% market weighted average dividend yield and 4.7% growth in cash flow from 2007 to 2008.

It described health care REIT assets as triple-net leased to operators with cash flow cushions that exceed 20% at the operator level. The long-term leases provide stable incomes growing at or above the rate of inflation, it added. “The performance of other assets, such as medical office buildings, should be minimally affected by recession,” Stifel noted.

Meanwhile, the group’s dividends represent only about 82% of cash flow and are likely to grow at a number of companies in 2008, Stifel pointed out.

“We believe health care REIT 2008 cash flow could actually grow more than we currently estimate because health care REITs now face less competition for properties from private-equity buyers and because borrowing costs for operators have risen, likely increasing the yield REITs will be able to obtain on future leases,” it added.

So, why then are these stocks down? Stifel theorizes it is largely because the increased use of index funds tends to cause all REITs or all small caps to move in the same direction as the broader market.

“For those investors still willing to pick individuals stocks or small sub-sectors, such as health care REITs that represent less than 10% of the REIT index, we believe health care REITs have very attractive counter cyclical fundamentals and good dividend yields that make them attractive in an economic downturn,” Stifel asserted.

The brokerage singled out five issues that it rates as a buy, listed in in the November issue of Yields & Income Newsletter.

Energy MLPs/Credit Suisse Securities

The investment bank recently spelled out its case for the asset class to outperform other high-yielding investments in a detailed 10-page report.

“We believe that MLPs provide a compelling valuation proposition for investors relative to other yield investments, including high yield debt, regulated utilities, and REITs,” it asserted. It noted that MLPs currently pay a dividend yield of 6.2% compared with high yield debt at 8.5%, regulated utilities at 4.4%, and REITs at 3.8%. It estimated that the MLPs in its universe will be able to grow distributions through 2010 at a 5.1% annualized rate, which it deemed to be in-line with REITs and superior to regulated utilities. “Parity with other high yield investments implies a 40% upside,” Credit Suisse added.

The bank asserted that recent weakness in the group has provided a good entry point into what it called liquid names with strong growth and high dividend yields. The six names it singled out all have large capital expenditure programs that should drive distribution growth, the bank explained. See the November issue of Yields & Income Newsletter for more.

Utilities/Credit Suisse

CS recently reiterated its outperform rating on Dominion Resources and slightly lifted its price target on another, CenterPoint Energy.

Municipal Bonds/Citi Investment Research

Citibank recently pointed out that two developments in Washington could have a big impact on municipal bond investors.

First, there is the controversial issue of the Alternative Minimum Tax (AMT). Citi noted that House Ways and Means Chairman Rangel recently introduced a comprehensive tax bill that would, among other features, eliminate the AMT for individuals. “There is little chance that any plan to eliminate or permanently ‘fix’ the AMT will be put in place prior to the presidential election,” Citi stressed.

Rather, it expects a “patch” will be renewed for 2007 and even 2008. However, the renewal would be sufficient enough to keep the number of taxpayers who pay the AMT from soaring from around 4 million to more than 20 million, which has been forecasted.

While this uncertainty plays out, Citi pointed out that the yield spread on AMT munis over similar non-AMT paper is now as wide as it has been for quite a while—about 25 basis points. “For investors who do not expect to be in the AMT in 2007 or 2008, this spread makes AMT paper attractive,” it asserted. This is because the bank expects some sort of “fix.”

“Once that occurs, we believe there will be a well-defined group of investors who are confident that they do not have an AMT ‘problem’ and who will be willing to purchase AMT paper at a narrower spread over non-AMT issues,” it added.

The second issue is the Supreme Court case, Davis v. Kentucky, which is challenging the ability of states to tax interest on out-of-state bonds while exempting in-state paper, according to Citi. It noted that several articles have predicted dire consequences for munis if the states lose the right to make this distinction.

“In our view, there will be a cost if this occurs, particularly for small issues in high-tax states, but for larger, more liquid issues, the increased cost for bonds issued in high-tax states will be modest,” Citi told clients. The reason: The market has already built into prices the possibility of a ruling against the states.

It pointed out that yield spreads on high-tax state bonds against general market bonds are typically 10 basis points or fewer. It recommended investors consider diversifying into general market paper issued in the limited number of that states that don’t have an income tax, such as Texas, Washington and Florida, or don’t exempt most in-state paper, such as Illinois.

Meanwhile, in a separate report, Citi asserted that the muni market is once again beginning to be priced attractively. “Muni yields as a percentage of Treasury yields [are] once again reaching levels we consider unsustainably high,” it explained. “Investors should expect continued volatility, somewhat less liquidity on large blocks, and the other patterns of thinner trading. For the buy-and-hold investor, this is likely to mean that being nimble and opportunistic as the muni market bounces around will provide rewards.”

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