Income Security Recommendations

BondsOnline Advisor – March 2006
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.

Merrill Lynch/Utilities
Utilities analyst Steve Fleishman is looking for a flood of M&A deals in the utilities industry for the first time since the late 1990s. What’s driving this likely trend? Size, regional or fuel diversity, rising cost pressures, more options post-PUHCA (the Public Utility Holding Company Act of 1935), and a more pragmatic FERC. He points out that the recent deals have been big-to-big with low premiums, characteristics it anticipates continuing with future deals.

Even so, Fleishman does not recommend a broad investment strategy to buy utility M&A candidates, given currently low premiums and approval timelines generally still a year-long process. So, he recommends “attractive stand-alone stories and cheap relative to their assets.” This includes two utilities currently with buy-ratings: PPL Corp. (PPL), with a current yield of 3.60 percent, and DPL Inc. (DPL), whose yield is 3.70 percent. He also likes Exelon Corp. (EXC), whose yield is 2.90 percent, and FPL Group (FPL), with a yield of 3.80%, whose mergers should both close later this year.

As an added bonus, Fleishman points out that legendary investor Warren Buffett recently indicated he’s interested in making additional utility purchases.

Merrill Lynch/MLPs
The investment bank likes a number of natural gas pipeline Master Limited Partnerships (MLPs). In fact, it just initiated coverage of TC Pipelines, L.P. (TCLP) with a “Buy” rating and a $36 price objective. The company is a subsidiary of TransCanada Corp., and was formed to acquire, own and participate in the management of U.S.-based natural gas pipeline assets. Merrill notes that this stock is appropriate for investors seeking lower risk. Its current yield is 6.80 percent, slightly higher than its group, and its estimated 4 percent cash distribution growth rate is in line with its peers.

Merrill Lynch/REITs
Blackstone’s recent announced plans to buy Carr America for $44.75 a share “was an eye-opener,” as it signaled to many investors that there are large pools of capital looking for a home in the real estate industry and any arbitrage between public and private values will be quickly closed through M&A activity, the investment bank points out. As a result, it now believes many more REITs can now be viewed as potential M&A candidates assuming the debt markets remain accommodative and cap rates remain stable.

In general, Merrill points out that the dividend yield on the REIT sector stands at 4.09% and the spread to the 10-year Treasury yield (4.64%) is currently -55 bps while the spread to BBB Corp Bonds stands at -206 bps. However, relative to the S&P 500, the dividend yield spread is 224 bps (4.09% versus 1.84%), which is well below the long-term average of 474 bps.

Here are the current average yields for the various sub-sectors:
Apartment Average: 4.0%
Neighborhood Shopping Center Average: 4.4%
Regional Mall Average: 3.8%
Office Average: 4.1%
Industrial Average: 3.2%
Self-Storage Average: 2.6%
Manufactured Home Average: 0.2%
Triple Net Lease REITs Average: 6.7%
Diversified REITs Average: 3.9%
Total Sector Average: 4.0%

Merrill also said it recently lifted its price objective on two stocks: Vornado (VNO) from $93 to $99, and with a yield of 3.40%, and Tanger (SKT), from $32 to $35, and a yield of 3.80%.

UBS/Bonds
The investment bank’s economics group now believes the tightening cycle will top out at 4.75% this year because growth has been more front-loaded this year than initially forecast. Its recommendation: For taxable bonds, the 4- to 7-year portion in the yield curve; in municipals, investors with disproportionately large allocations to cash should actually consider extending into the 10- to 15-year range since they are carrying reinvestment risk. Also: maintain a neutral duration weighting.

Baring Asset Management
Alan Wilde, Director, Fixed Income & Currency, says his firm “applauds the responsible policy moves from emerging market nations that have resulted in much greater credit quality and justifiably tighter spreads versus emerged market debt. He notes that external debt buybacks from Latin American countries have added more incentives to investors, causing spreads to contract to record levels. Comments Wilde, "Without question, emerging market debt is a fundamentally different beast that it was five or ten years ago, presenting responsible investors with real choices.” However, he warns not to forget that the history of many of these countries suggests things can go wrong, “and when they do, they go wrong badly. It would not take much to shake up these markets, and we suggest that investors stay vigilant."

Lehman Brothers
Chief US Economist Ethan Harris raised his Fed Funds forecast to peak at 5.5% after the August or September FOMC meeting. “The move is spurred by the surprisingly slow rate of cooling seen thus far in the housing market, and the continued signs of strength in the US economy,” the firm adds. Harris expects the yield curve to remain inverted, with yields on the 10-year Treasury note to hit 5.2% by the third quarter. He also raised his GDP growth forecasts for the next three quarters.
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SmithBarney
With intermediate and long-term interest rates at their highest levels since the first half of
2004, SmithBarney is asking what most income-oriented investors are thinking: is this a good time to put cash to work, or is it merely the beginning of a cyclical move toward ever-higher long-term rates?

The investment bank says the answer is fairly clear: the move is likely to be self-limiting, and rates are probably quite close to ultimate highs for this cycle. It adds that after identifying key reasons for the recent rate run-up, it can “make a strong case” for continuing to move out of cash and out along the yield curve over time.

It asserts that even though short-term yields have become more compelling, it believes some of the best values are to be found in the intermediate-maturity range. It points out that the differential in yield between intermediate and long-term rates has declined sharply. It notes that at the beginning of 2005, 30-year Treasuries yield 60 basis points more than 10-year issues, now the difference is slightly negative.

In the municipal market, SmithBarney’s preferred range is 8–13 years while in taxables “it is somewhat shorter.” It adds: “In our view, putting a portion of existing cash to work now, and continuing to ease into the market over time is an appropriate strategy given current conditions.”

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