utility bond

utility bond

A long-term debt security that is issued by a utility.

Please compare the risk and return on utility bonds vis-á-vis risk and return on industrial bonds.

Utility bonds, like industrial bonds, range the full spectrum with regard to credit quality. Some utility companies have been able to successfully overcome more difficult times associated with bringing large construction projects into their ratepayers' rate base, thus enabling the companies to pass on to these ratepayers the costs of constructing the projects. Other companies have been forced to pass some or all of these costs on to their stockholders, meaning that these companies' earnings have been hurt severely. (The harm to earnings, of course, also adversely affects the utilities' bondholders because these companies' financial ratiosthat is, interest-coverage ratios and debt to equity ratiosare reduced and credit rating agencies are likely to reduce credit ratings as a result. Lower credit ratings translate into higher bond yields and lower bond prices for bondholders.) This is an extremely abbreviated and simplistic explanation of why utility bonds at one time traded at relatively wide yield spreads to industrial bonds. The utility companies' financial ratios were influenced by political factorssuch as whether the elected public utility commissioners would permit their reelection chances to be harmed by passing on unpopular rate increases to those same ratepayers who elected themin addition to all the other factors that were almost beyond the control of the utilities, for example, high interest costs, energy conservation efforts, and environmental concerns. These factors all contributed to the market's perception of greater risk in the utility industry. Some of the factors have changed; others have been overcome by time, as projects have been completed and put into the rate bases of the utility companies of the nation. Still other very positive trends have occurred (such as high interest costs having been reduced through refinancing at lower interest costs). Now we observe that many utility companies are becoming cash cows. The excess cash flows generated by some of them have enabled them to buy companies in nonregulated industries, thus reducing their vulnerability to political influences and allowing them to participate in more growth-oriented businesses. In short, in many cases utility companies are turning the corner on their past problems, and their bonds are trading more and more like industrial bonds in those selected cases.

Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD