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Building The Core With Vanguard: Domestic Bonds

Summary Every ETF investor needs to consider what holdings will form the very core of their portfolio. For the portion relating to domestic bonds, Vanguard’s Total Bond Market ETF is a compelling choice. Also discussed are reasons every investor should consider holding bonds in their portfolio, despite what is often described as a negative current environment. For my first articles for Seeking Alpha, I decided to start simple: tackling the question of building a solid core portfolio using ETFs offered by Vanguard Funds. I started with domestic stocks featuring the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). For this second article, I turn to domestic bonds, and will be featuring the Vanguard Total Bond Market ETF (NYSEARCA: BND ). Bonds? Now? Really…? This might seem an odd time to be featuring bonds. After all, interest rates are at, or close to, historical lows, and common wisdom says they are sure to rise from here. Couldn’t our time be better spent considering other options? I might best answer that question by sharing a personal observation of mine. I tend to have CNBC.com up most of the time as one of the tabs in my browser. Last July (2014), this article titled “Why a $60B fund manager is sitting on 20 percent cash,” featuring BlackRock portfolio manager Dennis Stattman, caught my eye. To explain why he was sitting on 20% cash, the article starts with this attention-grabbing quote from the fund manager: “We don’t like the bond market.” The article goes on to enumerate all of his reasons for that view. But once you got past all that, here was the part that caught my eye. His allocations were 58% in stocks, 23% in bonds , and 19% in cash. My takeaway: Regardless of his stated feelings concerning bonds, that fund manager still had some portion of his portfolio in that asset class. Here is a second point of reference to consider. This resource from Vanguard features historical returns going all the way back to 1926 for various model portfolios, in 10% intervals – ranging all the way from 100% stocks and 0% bonds to the other extreme, 0% stocks and 100% bonds. I selected two of these to look at quickly. The first, a portfolio with 100% stocks, and the second with 60% stocks and 40% bonds: I won’t belabor the points, but a couple of things jump out. On the one hand, the allocation with 40% bonds has an average annual return of 1.4% less than one with 100% stocks. On the other hand, the worst single-year loss is 26.6% as opposed to 43.1%. Depending on a vast array of variables – including the possibility of having to sell at precisely the wrong time due to personal financial circumstances – that could make a big difference. You also derive consistent income from bonds (although, admittedly, not so much at present). This can provide you with funds to reinvest in whatever asset class you wish. Putting it all together, that BlackRock investment manager, at some level, had virtually a 60/40 stock versus bond allocation, but he chose to hold 19% in cash because he “[didn’t] like the bond market.” On a personal note, at the time that this article caught my eye, my personal bond allocation was higher than his, and I actually made an adjustment to bring it more in line with what he was doing. In summary, while you may make various decisions as to their weighting , if you believe in a disciplined portfolio as opposed to market timing, bonds deserve a place. And That Brings Us To BND (Composition) What makes BND such a good ETF to serve as the core for this portion of your portfolio? I believe it boils down to two factors: Outstanding diversification Reasonable duration BND tracks the Barclays U.S. Aggregate Float Adjusted Bond Index . This includes a wide range of government, corporate, and even international dollar-denominated bonds. All are investment-grade (Moody’s rating Baa and above), meaning you are not getting into “junk bond” territory in this particular ETF. I will have more on the risk characteristics below. The fund does not actually own every constituent in the index, but rather samples the index, holding a basket of securities that approximate the full index. The latest datasheet reveals 9,330 bonds in the actual index and 7,364 in the fund itself. As featured in this introductory article , bonds have two main risks: interest rate risk and default risk. Fortunately, the information that you need to evaluate this is provided on the datasheet for any bond ETF you are likely to consider. Here is that information directly from the latest datasheet for BND: (click to enlarge) Interest Rate Risk Let’s start with interest rate risk. When it comes to a bond mutual fund or ETF, the key data point that you need to identify is the fund’s duration . Once you identity this, the general rule is simply to multiply the fund’s duration by the change in rates . In other words, if a fund has a duration of 2 years and there is a 1% upwards move in interest rates, the value of the fund is likely to decrease by 2%. This is intended to be a general guideline as opposed to a precise number, because interest rates may rise or fall by different amounts across various terms. As an example, BND holds bonds with maturities basically ranging from 1 year to 30 years. Still, this serves as a reasonable measure of the amount of risk that you are assuming. With that in mind, note the average duration of 5.6 years displayed on the datasheet for BND. Given that, a 1% increase in interest rates could lead to a temporary loss of 5.6% of principal. I say “temporary” because unless you need to sell, this is only on paper. Remember, bonds have a face value , and this is the amount the bond is ultimately worth on the date of maturity . Also, when evaluating this, perhaps against just leaving your money in cash, consider the current SEC yield (as of 6/9/15) of 2.06%. Default Risk The second main risk with bonds is default risk. This refers to the possibility that the issuer could experience financial difficulties such that they are unable to meet the obligation to pay the face value, to return the original capital invested. Fortunately, ratings agencies rate the creditworthiness of bonds on a descending scale. Even more fortunately, default data is available for each rating category, due to the Municipal Bond Fairness Act of 2008. With that in mind, here is my analysis of this risk for BND: Essentially, I started with the weightings by Moody’s rating as published on the BND datasheet. I then multiplied this by the default risk as identified in the above-linked report, to arrive at a weighted default risk. For BND, my calculation reveals a default risk of .86%. The counterpoint to that, of course, is that lower-rated bond issuers have to offer a higher coupon or interest rate to attract buyers for their bonds. So, funds have to pick a balance of risk/reward. In other words, how far down the scale of default risk are they willing to go in search of higher returns? In the case of BND, the lowest rating currently accepted in the ETF is Baa , which is defined by Moody’s as: “… judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.” You may also note that, cumulatively, 86.2% of the fund’s securities are rated A or higher, with 63.4% in government securities, which are generally considered to be virtually free from default risk. In summary, BND is a solid core holding because of its moderate duration (5.6 years) and credit (or default) risk, due to all holdings being rated Baa and above. Costs and Expenses Similar to that of VTI, BND carries one of the lowest expense ratios in the ETF marketplace, at .07%. To that, of course, you have to add your trading commissions. Vanguard offers its own ETFs commission-free, and TD Ameritrade offers a decent selection of commission-free Vanguard ETFs. Suitability As a core holding, BND is suitable for all portfolios. Alternatives Other ETFs worth considering, particularly if your broker offers them commission-free, are the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) and the iShares Core U.S. Aggregate Bond ETF (NYSEARCA: AGG ). SCHZ features an industry-low .05% expense ratio, and AGG comes in at .08%. However, even if your broker offers commission-free trading on one of these alternatives, I might still hold BND as a core position and use one of the commission-free options to make small incremental purchases, such as monthly or quarterly investments, adjust portfolio weighting and the like. As a Fidelity client, this is how I use BND and AGG (commission-free trading) in my own portfolio. Last-Minute Personal Comments As I complete this article, the interest rate environment continues to be volatile. If you are considering an initial investment in bonds at this point, I might offer two suggestions: Consider establishing your initial position in multiple increments – perhaps 25% at a time. In so doing, if interest rates rise and prices drop, you will gain some proportionate benefit. Of course, this means a commission on each transaction (for most of us), but the benefits may offset this. Consider using another Vanguard ETF, the Vanguard Short-Term Bond ETF (NYSEARCA: BSV ), for some portion of your position. This ETF has a duration of only 2.7 years and a current SEC yield of 1.08%. The trade-off, as you can clearly see, is a little less income in return for less downside risk. Disclosure: The author is long AGG, BND, BSV, VTI. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I am not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes, and to consult with their personal tax or financial advisors as to its applicability to their circumstances. Investing involves risk, including the loss of principal.

CenterPoint Energy: Houston’s Not So Bad

Long/short equity, value, research analyst, growth at reasonable price “}); $$(‘#article_top_info .info_content div’)[0].insert({bottom: $(‘mover’)}); } $(‘article_top_info’).addClassName(test_version); } SeekingAlpha.Initializer.onDOMLoad(function(){ setEvents();}); Summary Heavily Houston-focused profit center, accounting for two-thirds of total operating income. Electricity demand fears for the area may be overdone. 3%-4% earnings and cashflow growth FY’15-17 would support equivalent dividend growth rate. DCF valuation suggests value of $24.50 per share. CenterPoint Energy’s (NYSE: CNP ) primary business focus is around the Houston area, which along with the downturn in the Oil & Gas industry, are two issues weighing heavily on CNP’s share price. Demand may be more resilient than what investors expect. However, even a 3%-4% earnings and cash flow CAGR outlook will support an equivalent dividend growth rate. The prospective dividend yield of nearly 5% looks attractive, with CNP yielding over 100 bps more than its peers. Income investors should start to circle. Houston-focused business activities delivered two-thirds of operating income last year CNP’s Houston-focused electrical transmission and distribution business delivered around two-thirds of the company’s total operating income in FY’14. Because of this, concerns around job losses in the area and the sharp downturn in the oil & gas industry have impacted sentiment in the CNP share price. That said, the CNP management team believes that Houston’s Head-office status, as opposed to Operating company status, could leave it more resilient to job cuts and thus electricity demand than the stock market believes. Q1-15 customer growth rate of 2% supports this theory. Utility Rate Relief possible in H2-15, one of two possible share price catalysts CNP’s Natural Gas Utilities have filed this year for a combined $20 million rate increase via four recovery mechanisms and one rate case, each with expected 2H-15 effective dates. Management also plans to file rate cases in Minnesota and Arkansas in 2H-15. Management spoke constructively of recent regulatory reform in Arkansas that is expected to reduce the regulatory lag going forward. News on this could act as a share price catalyst along with clarity on the long-term dividend growth outlook. Management has promised to update investors on this in August. DCF methodology suggests value of $24.50 per share My DCF model suggests an implied fair value of $24.50 per share based on conservative assumptions. There are also two possible share price catalysts looming and the stock dividend yielding around 5% on a prospective basis. I think that CNP is worth a second look. Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in CNP over the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Share this article with a colleague

SCANA Corporation: A Value Play On The Utility Sector Pullback

Summary The Utilities Select SPDR Fund has seen a double digit pullback from 52-week highs. SCANA Corp. has seen even greater losses, with a share price now down over 20% from January highs. This hefty pullback has brought SCANA back into fair value, and provides a nice entry point for long term investors. Background On January 21st, I wrote an article discussing the high valuations being seen among the utilities: ” Have We Reach The Point Of Irrational Exuberance In The Utility Sector? ” It turns out this article was published just one week before the 52-week high was made in the Utilities Select SPDR ETF (NYSEARCA: XLU ). Since then the sector has been in sell-off mode, as interest rates have started to rise and continued fears of a Federal Reserve rate hike looms. One of the utilities hit the hardest during the pullback has been SCANA Corporation (NYSE: SCG ), whose shares are down over 20% since the article was published. This divergence can be seen quite clearly in the chart below. 10 Year Treasury Rate data by YCharts SCANA has seen a 50% greater correction than the rest of the sector, and as a result is now trading below fair value for the first time since the end of September, 2014. (click to enlarge) For those not familiar with F.A.S.T. Graphs , the chart above shows the share price in relation to the PE trendline over the last five years. With the recent pullback, you can see where the share price has retreated to below the long term blue 14.3 PE trendline, which represents the average PE during the period. This is the first time SCANA has traded at that level since the end of September. Company Operations & Guidance SCANA Corporation is an energy-based holding company that is headquartered in Cayce, South Carolina. SCANA was formed in 1984 and currently serves over half a million electric customers in South Carolina and more than 1.2 million natural gas customers in South Carolina, North Carolina and Georgia. These service territories can be seen below, as depicted on page 9 of the company’s March presentation . (click to enlarge) SCANA has a diversified mix of power generation capabilities with assets in coal, natural gas, nuclear and renewables. Coal currently comprises roughly 50% of the mix, but that will be decreasing in the future as the company is in the process of adding two more units to its V.C. Summer nuclear plant, which will shift nuclear to 56% of dispatch power when they are completed. (click to enlarge) This has resulted in a high amount of CAPEX due to construction costs of the new nuclear facilities. These expenditures are expected to peak in 2016 and then continue downward until the new units are commissioned in 2019 and 2020. (click to enlarge) These expenditures have continually been adjusted upwards as the project progresses and this may be an item of concern in the future if there are further delays and cost overruns. However, thus far the company has maintained its stable BBB+ credit rating and appears to have these future costs accounted for with debt offerings and expected rate increases to consumers. Company Performance SCANA has been an excellent performer throughout the years, as it is a Dividend Contender from David Fish’s CCC List , and owns a 15 year streak of increasing dividends. During this period, the company has been able to grow earnings and dividends at a steady rate, with a long term EPS growth rate of 3.9% and a dividend growth rate of 4.4%. (click to enlarge) This consistent performance has led to outsized returns when compared to the market. With reinvestment of dividends, SCANA has produced annualized returns of 8.4% over the period, which crushed the S&P mark of 5.3%, and led to twice the total returns over the period. (click to enlarge) Another highlight to note is that investors who bought at the end of 2000 did so with an initial yield of 4.0%; and through the compounding power of reinvestment and dividend increases achieved a yield on cost over 10% after 10 years. Those investors would now be receiving 12.3% of their initial investment in annual dividends. Shares are yielding 4.3% with the recent pullback, and as things currently stand, investors have a good chance of seeing a similar situation play out over the coming decade. The company is currently projected earnings growth of 3-6% over the next few years. Analysts agree, and project the high end of this range was they expect 4-6% growth over the next 5 years. Using the mid-point of guidance, here are the income projections over the next 10 years with the reinvestment of dividends. Going back to F.A.S.T. Graphs and using the handy forecaster tool with a more aggressive estimated earnings growth of 6%, new investors could hope for annualized returns of nearly 12%. (click to enlarge) 12% annualized returns may not sound like much compared with what we’ve seen in recent years in the market, but it’s still well above historical returns, and doesn’t take any outlandish predictions for it to work out. Even dropping the growth rate down to the low end of guidance would lead to annualized returns of nearly 9%, which is a nice risk/reward type of investment. Investment Risks While SCANA is certainly becoming attractive at current prices, the pullback in the sector may not be over. Treasury yields have been on a steady rise since the beginning of the year, and as long as they continue rising there could be continued weakness in the utility sector. Additionally, the company does have some risk of its own with construction costs associated with the expansion of their nuclear power plant. Any further delays would lead to higher costs, and could lead to lower dividend and earnings growth rates than what is currently forecast. Conclusion SCANA Corp. appears to be an attractive income play in the current market environment. The company looks to be financially sound with a BBB+ credit rating and provides an appealing 4.3% yield that is expected to grow at a 3-6% annualized rate going forward. With shares currently below historical valuation levels, total return investors could also be looking at high single digit annualized returns. There could still be some downward pressure on shares if interest rates continue to rise, but the relatively high dividend yield pays you to wait for the rebound. Personally, I am looking to add another utility or two to my portfolio , and am strongly considering SCANA, along with several others on my watch list. I am currently looking for possible sales to free up capital for a purchase, and may be initiating a position within the next week or two. Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in SCG over the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I am a Civil Engineer by trade and am not a professional investment adviser or financial analyst. This article is not an endorsement for the stocks mentioned. Please perform your own due diligence before you decide to trade any securities or other products.