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VSCSX: High Quality Short Term Corporate Debt May Be On Sale In December

Summary The Vanguard Short-Term Corporate Bond Index mutual fund is everything I would hope for in a short-term corporate debt exposure. The mutual fund has low volatility and low correlation with other important investments. The Federal Reserve may push up yields and put high quality bond funds on sale in December. The Vanguard Short-Term Corporate Bond Index Admiral Shares (MUTF: VSCSX ) is simply a great fund. I wish I could start more articles out with comments that are this positive. This fund is simply great. The yields are severely limited since this is short term debt with respectable credit quality, but the ETF on the whole is just exceptional when it comes to being part of an effective portfolio. Duration The following chart breaks down the duration of the funds. Holdings are almost all less than 5 years and usually more than 1 year. Again, this is a solid choice. If an investor wants to load up on even shorter term bonds, there are funds designed specifically for that. It is difficult to find a useful yield level on those ultra-short bonds so this is a reasonable portfolio composition. Credit The following chart shows the credit quality breakdown. When it comes to a corporate bond fund there are two ways that I like to see the weightings. Either I would want a junk bond fund or I would want one with a credit breakdown similar to this. Personally, favor combining a fund like this with quite a few other bond funds to create a more complex group of bond holdings. Sector The following chart breaks down the sector allocation: This sector allocation may seem absurd if an investor looks at numbers without reading the names. The names of the sectors indicate that rather than breaking down the market into all the corporate sectors, Vanguard is containing several other bond sectors that are not relevant to corporate debt. It wouldn’t make sense for this fund to have an allocation to foreign debt issues or MBS. Portfolio Usage When the mutual fund is placed within the context of a portfolio that is heavy on U.S. equities it looks like an intelligent way to reduce the overall risk of the portfolio. When it comes to generating alpha, I’ve often told investors that the secret to reaching alpha is to focus on reducing risk. (click to enlarge) Most other investors are already focused on trying to maximize their returns and many will take on more risk than they can handle. Focusing on risk reduction reduces the incentives for an investor to sell off after a big loss and makes it easier to generate alpha relative to the S&P 500 because it is easier to reduce risk through superior diversification. In this case we can see that the return on the fund was fairly weak over the last several years, but the annualized volatility has also been fairly low. When consider that the total risk contribution to the portfolio is negative due to the fund having a negative correlation with the S&P 500, the impact on risk adjusted returns is much more favorable than it would have appeared at first. These bonds do take on some credit risk as corporate debt, but the fund is not holding junk bonds so the credit risk is not material enough to outweigh the impact of a small amount of duration risk. As a result, investors end up with a negative correlation between this fund and most domestic equity funds. One Risk Factor The biggest risk factor for this portfolio right now is the potential for share prices to drop if the Federal Reserve is able to raise rates in December. I’m treating an increase in rates as a buying opportunity for any rate sensitive asset. That could mean bond funds, equity REITs, mREITs, or utilities. Regardless, I’d like to have a little cash available this December to see if the Federal Reserve is able to push some of the investments I want into the bargain bin. Another Use Investors that want to keep a fairly short amount of duration exposure in their portfolio while maintaining higher yield may consider this bond fund as part of an automatic allocation strategy within retirement portfolios. The yields aren’t going to be incredible, but for an investor that is feeling particularly risk averse this is a fairly nice fund. Since volatility is fairly low, it isn’t likely to move up or down very far, but it does offer some gains over time while making the portfolio less risky. Conclusion This mutual fund offers high quality corporate debt that will offer superior yields to treasuries but it still has a negative correlation with equity securities. The return is severely limited by short duration and high credit quality combining to create very low yields on the bonds, but it still makes sense for investors looking for some less volatile investments. If the Federal Reserve moves to raise rates it could put this fund on sale for a bit in December which would create a nice buying opportunity.

VUIAX: This Utility Mutual Fund Is Keeping The Lights On

Summary VUIAX has a respectably low correlation to SPY, but the correlation and relative volatility have changed materially over time. The expense ratio is great for an investor wanting some cheap diversification throughout the utility sector. I expect the Federal Reserve to push hard for raising rates in December, but I don’t think rate increases can be sustained. Utilities are sensitive to interest rates, so an increase in rates would trigger lower prices and a buying opportunity. In my past analysis on other utility mutual funds and ETFs I have found they can offer some nice benefits to the portfolio from lower levels of volatility and lower levels of correlation to the S&P 500. However, finding a good utility mutual fund can be a problem because a high expense ratio can destroy a fund that would otherwise be very attractive. Since the Vanguard Utilities Index Fund (MUTF: VUIAX ) has an expense ratio of only .12%, I’m feeling pretty optimistic going into this one. Does VUIAX provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. When I ran a regression on SPY and VUIAX, I found a correlation of 78%. That isn’t very low, but it is not high enough to be problematic. I found the annualized volatility for VUIAX was 18% since February of 2004, which was slightly lower than the overall market at 19.4% during that time span. However, if an investor focuses only on the last couple of years the resulting volatility levels are significantly less favorable for VUIAX. Over the last 24 months the annualized volatility on VUIAX was 14.8% and it was only 13.1% on SPY. On the other hand, during those 24 months the correlation was only around 53% rather than the longer term average of 78%. Expense Ratio The mutual fund is posting .12% for an expense ratio. What else is there to say? That is a solid expense ratio. Largest Holdings The diversification within the mutual fund is pretty weak. For a very long term holder it might make sense to replicate the mutual fund by just buying the underlying securities and taking higher trading costs to eliminate the expense ratio. However, an expense ratio of only .12% would be difficult to beat without a fairly long time horizon or a large volume of commission free trades in the account. (click to enlarge) The major holdings here are the same ones I would expect to see. Duke Energy Corporation (NYSE: DUK ) is a fairly huge utility company and frequently at the top of the list for utility mutual funds. All around this appears to be a reasonable portfolio for an investor that wants to get more utility companies into their portfolio without having to buy the companies individually. Why Utilities Investors may be wondering why they should look to raise the utility allocation when the Federal Reserve is talking about raising rates. Since utilities tend to have some material correlation to corporate bond funds, it would seem like an allocation to utilities would be dangerous. When it comes to the Federal Reserve, my stance is that they can’t raise rates as rapidly as they would like to raise them. Because I expect them to substantially underperform their projected trajectory, I see the December meeting as potentially providing a great entry point for equity REITs, utilities, and bonds. I see the potential for weaker prices as being indicative of solid entry points, it simply requires having the conviction to pull the trigger right when everyone else is bracing for higher rates. Conclusion Utility companies can act as a form of income investment because of their strong dividend yields. Unlike buying into a bond portfolio investors can expect that the level of dividends will be increasing over time which makes up for the portfolio having more risk than a simple bond portfolio. When it comes down to designing an ideal portfolio, I think there is a viable argument for running a higher allocation to the utility sector as a way to improve diversification throughout the portfolio. The biggest weakness for using utility companies as a way to diversify the portfolio is that the diversification benefits of the utility allocation are not as strong as the benefits from simply using a diversified bond portfolio since bonds have historically shown materially lower correlations with the S&P 500. If an investor already has a large allocation to bonds, the benefits of adding VUIAX will not be as strong. On the other hand, if an investor places a high value on getting qualified dividends as a source of income, it would materially increase the relative attractiveness of VUIAX. In those cases, it would make sense to use a stronger allocation to VUIAX to reduce portfolio risk.

Westar Energy: A Progressive Utility With A 3.5% Yield

Summary Westar Energy harnesses wind in Kansas for cheap power. Westar Energy retiring three old coal and gas plants. Westar implemented a $78 million rate increase in October. Westar Energy (NYSE: WR ) is a progressive utility company that is aggressively moving to clean power. Westar Energy plans to nearly double its clean power while reducing fossil fuel energy by 7%. In my previous article about Westar Energy, I told investors to buy this stock around $37 per share as the company adds cheap wind power while reducing coal. Kansas has some of the strongest winds in the country. Westar is prepared for tougher environmental regulations from the Clean Power Plan. The Clean Power Plan establishes state-by-state targets for carbon emissions reductions, and it offers a flexible framework under which states may meet those targets. The final version of the rule would reduce national electricity sector emissions by an estimated 32% below 2005 levels by 2030. Westar Energy has sufficient capacity right now to meet demand. But on a conference call with investors, Mark Ruelle, president and chief executive officer, said the investment in wind is primarily because it’s so inexpensive with the tax credits. The move also is a bit of a hedge on what form the Clean Power Plan takes in Kansas. Ruelle said wind energy is a bargain right now. (click to enlarge) Ruelle said Westar Energy has sent out requests for proposals to add another 500 megawatts of power. Right now 9% of Westar’s generation is from renewable resources, but that number will grow to 17% of generation in 2016. Nearly all of this energy will be from wind. Westar Energy’s energy generation mix includes 700 megawatts from wind energy, with commitments to add another 600 megawatts under development for a total of 1,300 megawatts. In addition, Westar is now considering adding another 500 megawatts on top of the 1,300. “We’re continuing to evaluate, but right now it looks like it makes more sense for our customers if we own all of our sizable portion of the incremental renewables,” Ruelle said. “Today our renewables portfolio is heavily imbalanced for PPA (Purchase Power Agreement) vs. ownership and if we don’t re-balance it a bit that might set us and our customers up for problems down the road when the PPAs expire, plus customer economics favor ownership,” Ruelle said. Westar Energy recently announced plans to close three small units at Lawrence, Tecumseh and Hutchinson by the end of the year. These are the first major unit that Westar has closed in the past few decades. The Lawrence and Tecumseh units burn coal, and the Hutchinson one uses natural gas. “It’s been good for our customers to hold on to these small old units as long as we reasonably could, but for a number of reasons, now is the right time to let them go,” Ruelle said. “They have lasted decades longer than anyone ever imagined, some of them are older than me, but given the clean power plan, their age, size and our need to manage expenses, it just doesn’t make sense to pour more money into them. They reflect two small 50s and early 60s vintage COLI units and a 60s vintage gas steamer. Together they are just 350 megawatts and less than 1% of plant investment.” Third quarter Westar Energy’s third quarter was sluggish. Cool-to-mild temperatures in August hurt demand for electricity. Westar Energy posted 3Q15 earnings of $138.2 million or $0.97 per share, compared with $146.9 million or $1.13 per share in 3Q14. Earnings for the nine-month period ended Sept. 30, 2015, were $253.4 million or $1.84 per share, compared with $270.3 million or $2.08 per share for the same period in 2014. The company has narrowed its 2015 earnings guidance range to $2.18-$2.25 per share from $2.18-$2.33. The company issued preliminary 2016 earnings guidance of $2.38-$2.53 per share. The company has strong financial strength. The company’s debt is investment grade. Total long-term debt was $2.941 billion at the end of 3Q15, compared to $3.224 billion at the end of 2014. The stock trades around 18.8 times earnings, which is a slight premium to its peers. Westar will see earnings improve in the fourth quarter and in 2016 due to implementation of a $78 million rate increase, approved by the Kansas Corporation Commission. Risks Utilities are sensitive to interest rates. When the Federal Reserve begins raising interest rates, these stocks are likely to take a hit. Utilities had a nice run up in 2014, but haven’t performed well in 2015. The Utilities Select Sector SPDR Fund (NYSEARCA: XLU ) is down -9.47% YTD. Westar stock has held up fairly well in 2015, down only -1.14% YTD. Ruelle said one large chemical producer had reduced consumption of electricity due in part to the low prices for oil. I believe we are near a bottom in oil but the price recovery will be slow and arduous. Weather is always a factor with utilities. Westar benefits from extremely hot temperatures in the summer and really cold temperatures in the winter. 2015 was mild to moderate most of the year in Kansas. Conclusion If Westar falls into the high $30s again, investors may want to consider buying the stock. Westar is a well-run utility with strong financials and steady income. The stock offers a yield of 3.5% with potential for modest appreciation. I bought WR at $37.03 on Aug. 27, 2015. The stock recently traded at $41.32 per share, a gain of 11.58% plus the gain from the $0.36 dividend for a total gain of 12.55%. I’m holding o nto the stock. Long-term investors will get the dividend and likely modest appreciation with a 12-month target price of $44.