Income Security Recommendations

BondsOnline Advisor – March 2008

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 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.

For a full list of this month’s recommendations subscribe to our Yield and Income Newsletter www.yieldandincome.com. The newsletter is also available to monthly and annual subscribers to PreferredsOnline – All Sectors, www.epreferreds.com

Equity Strategies

Credit Suisee: The investment bank pointed out that big cap companies have underperformed small caps by 11% in Europe and 6% in the US since the beginning of the year. This makes little sense to the firm’s strategists for a number of reasons.

For one thing, big caps have historically outperformed when the VIX—a volatility index--has risen and there is a higher level of uncertainty since this usually meant that investors favored diversified business models, which tend to be among the larger cap companies, according to CS.

Also, in the past 20 years when credit spreads have widened, big cap has outperformed 80% of the time, it noted.

The bank also asserted that lending conditions and business confidence are deteriorating more for small cap companies than for big cap companies.

Also, historically, big cap tends to outperform when leading indicators fall.

CS also said it believes the euro and sterling will weaken by year-end. “Big cap earnings are typically more exposed to overseas markets,” it added.

In addition, big cap valuations currently seem more attractive, as they trade on a 15% consensus forward 12-month P/E discount to small cap in the US and a 7% discount in Europe. “Typically big cap warrants a 6% premium in the US and 3% in Europe,” CS added.

Big cap also has a consensus dividend yield that is 1% higher than that of small cap in the US and Europe compared with an average premium of 30 basis points.

T.Rowe Price: The mutual fund company recently conducted panel discussions with some of its managers on the outlook for the U.S. equity markets and fixed income markets.

Brian Rogers, chief investment officer and manager of the Equity Income Fund, believes that investors will grow more optimistic as the year progresses and that this year will end up better than many market pundits currently expect. "Stocks will begin to perform better before investors feel better," he said. He believes better than expected corporate earnings, moderating interest rates, and a good valuation backdrop should enable equities to perform reasonably well in 2008.

Rogers also asserted that the long outperformance cycle for small-cap stocks, dating back to 1998, decisively ended in the second half of last year. He said they are expected to continue lagging larger stocks because small caps are more exposed to the domestic economy than larger companies and with much less of their revenue coming from overseas, they are expected to continue to lag large-cap stocks.

Rogers also noted that large-cap companies have more financial strength and are more diversified by product as well as geography. However, he does believe small-cap companies that can deliver solid earnings growth can perform quite well from current levels.

Although Rogers expects corporate earnings overall to show a single-digit gain this year, he stressed that many companies in various sectors will do better than that since the average is being dragged down by the financial sector, which has accounted for one-quarter of S&P 500 earnings. However, in general he expects earnings of smaller companies to continue to trail those of larger companies.

The money manager, in general, believes stock valuations are reasonable, especially relative to bond yields. He also asserted there are many high-quality companies selling at attractive levels.

Where to invest? Price’s managers said they are finding attractive opportunities in the depressed financial and consumer sectors as well as the technology, energy, and health care sectors. Larry Puglia, manager of the Blue Chip Growth Fund believes financial institutions will become much more profitable in the second half of the year and be on sound footing by year-end.

Utilities

Bear Stearns recently downgraded utilities to Market Underweight from Market Weight, citing a confluence of factors. “We believe that risks to the fundamental story are being largely ignored, sentiment has started to shift away from the group, and, at current valuations, the stocks are particularly vulnerable,” it stated in a recent report.

In general, Bear expects defensive stocks to fall out of favor. Sure, the US economy is slowing down thanks to tight credit conditions. However, the investment bank asserts that equities are poised for a move forward, driven by Fed rate cuts, fiscal stimulus and credit markets beginning to renormalize. “In conjunction with a market rebound, we expect a rotation toward cyclical areas and away from defensive areas, including utilities,” it noted.

Meanwhile, Bear thinks the utilities sector “is screaming expensive,” with valuations at extremes not seen in over 20 years.

Bear also believes sentiment is turning less positive. Although the sector outperformed the broader market over the past 12 months, since the Fed’s “surprise” rate cut on January 22, the sector has lagged, it noted. “We expect this trend to continue,” it added. “Additionally, short interest, a good contra-indicator, is at relatively low levels, pointing to future underperformance for the group.”

And, although fundamentals have been strong and are likely to remain solid, especially in deregulated businesses, Bear said it believes that stock prices already reflect very high expectations. “Moreover, we believe that the market is currently underestimating a number of potential risks to the secular pricing story, particularly on the regulatory front,” it added.

Energy MLPs

Lehman has Outperform ratings on at least five master limited partnerships, even though it reduced its price target on a couple of them.

NA: Not applicable

For complete list of the energy MLPs reviewed this month, including target prices, please see the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.

Deep Value Stocks

Lehman: What happens when the dividend yield exceeds the price-to-earnings ratio? Does this signal a company justifiably sold off because it is in trouble, or is there an enticing buying opportunity?

Lehman’s London team crunched the numbers and discovered that it offers a psychological measure of deep value on an absolute basis. More importantly, it found that companies continue to achieve a positive return for 20 months after the dividend yield exceeds the PE, racking up a total return of 60% over that period.

After 20 months, reversion sets in and the companies underperform, it conceded. “The performance is also strong relative to the market,” Lehman added. Indeed, the bulk of that 20 month return occurs in the first year.

So, the investment bank recommends that when buying these stocks, hold them for just a year.

Which companies currently meet the criteria? Lehman screened the 500 largest companies globally on this basis. The result: a list dominated by European Financials. It found if you screened for the largest 1,000 companies globally, it only adds Bank of Ireland and S-Oil Corp.

For a list of some of the companies whose yield exceeds the PE, see this month’s issue of Yield and

Preferred Stocks

UBS points out that preferreds are off to a phenomenal start in 2008, appreciating roughly 11% since their lows in late 2007. “Although the bulk of their price rebound has likely already occurred, we continue to look for the asset class to perform well this year,” it added.

Why? For one thing, there is an increased supply. So, investors now have more securities to choose from in both segments of tax-advantaged preferreds—DRD-eligible and non-US qualifying dividend income (QDI).

And although the reduced dividend tax rate is scheduled to expire at year-end 2010, UBS is not too concerned since the majority of tax-advantaged preferreds are not currently fully pricing in their tax benefit.

It explained that the future direction of tax policy is dependent on the 2008 US presidential election. It noted that John McCain supports making the Bush tax cuts permanent, while Barack Obama and Hillary Clinton are both in favor of allowing portions of the Bush tax cuts to expire for wealthy individuals. “Despite this legislative risk, however, we remain comfortable committing funds to the tax-advantaged segment of the preferred market,” UBS said. “Due to the supply surge, these securities are not currently pricing in their tax benefits, which helps reduce any price risk stemming from changes to the tax law.”

Municipal Bonds

Citigroup, the banking giant, recently told clients in a separate report that now is a great time to get back into munis. In a report screaming with the headline “An Unprecedented Yield Backup Creates Muni Market Opportunities,” Citi asserted that the muni market has fundamentally repriced in a matter of roughly a week.

It noted that yield spreads between triple-A uninsured paper and medium-quality revenue bonds have doubled in a short period of time. “While the unwinding of the pressures that triggered these increases may take some time, we believe that muni yields are close to a high-water mark for this cycle,” it argued.

Specifically, in just a week, yields in the intermediate high-grade range increased by as much as 66 basis points and credit spreads between what it calls the "natural" high-grades and medium-quality revenue bonds widened by 20 basis points to 30 basis points over the same period, creating a total increase in yield for medium-quality issues of as much as 90 to 95 basis points, according to a new report fired off by the bank. Long-term medium-grade revenue bonds, which Citi insisted are still generally quite solid credits, are now yielding 5.50 percent or more in many cases.

“With munis this cheap relative to taxable s, they become attractive to a new class of investors: institutions that will purchase them for a reasonable , steady-state yield to maturity, but also for a yield pickup over other instruments when and if yield relationships return to more typical levels,” Citi stated in the report. “This category will ultimately, we expect, include both leveraged and unleveraged investors.”

While acknowledging it could take weeks before the volatility in the municipal market calms down, it recommended investors get into the market now. “It is likely that the first snap-back could be quite rapid, as has often been the case in the past under more normal conditions,” Citi asserted. “So, in our view, it doesn’t make sense to attempt to ‘bottom pick’ the market by waiting until precisely the right moment to put cash to work.”

It suggested putting additional cash to work now and to lengthen the average maturity. “In our opinion, attractive values are available along the yield curve, with the unusually steep slope in the 10- to 20-year range providing a compelling case for moving out to the 20-year range for a portion of assets,” it stated. For trading-oriented accounts, longer-maturity municipals are likely to provide a superior total return when and if the muni market settles back into a more ‘normal’ environment, it added.

For complete coverage, please purchase the current issue of Yield and Income Newsletter. PreferredsOnline subscribers receive this monthly newsletter as part of their subscription.

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