Make sure you're holding water

Invest in water utility firms - at - the best of the week's international financial media.

For investors in water utility firms, the last decade and a half has been something of a choppy ride. When the companies were privatised in the early 1990s, their shares initially rocketed before falling back to earth in the latter part of the decade: the boom engineered by the US Federal Reserve Bank in the late 1990s made growth stocks all the rage, and steady dividend payers - such as utilities - very, very unpopular. Since then, however, investors, burnt by the dotcom fallout, have gradually begun once again to grasp the solid virtues of yield, and that means that the UK's water companies should once again be on every trader's radar.

Or so you'd think, says Tony Jackson in The Sunday Telegraph. But there is something a little odd going on in the investment world. We constantly hear that investors are "desperate" to make every scrap of yield they can and will run any risk to secure it. This has been true of bond investors for some time, but if equity investors feel the same way, why aren't they buying the UK's high-yielding shares? Consider the highest yielder in the FTSE 350, United Utilities. Its shares currently yield 7.4%. You might look at that return and think the firm must be in some kind of trouble (a high current yield is often a sign that a firm is expected to have to cut its dividend. But there's no trouble here: this is a water stock, a licensed monopoly with prices fixed by the regulator, prices that are now mapped out for the next five years. So what's the problem?

Bonds, says Neil Hume in The Guardian. A recent Government report out in the US showed the highest monthly rise in the producer price index for six years. This raised fears on both sides of the Atlantic that inflation is working its way back into the system, and that consequently interest rates would rise faster than expected. The result was a sell off in the Government bond market (the yield on ten-year US notes - which moves in the opposite direction to the price - rose to 4.26%) and a corresponding sell off in all other assets that are considered in terms of their yield, including water and other utility stocks in the UK. Utility stocks are often seen as an alternative to Government bonds because of their high dividend yields and the defensive nature of their operations, and they tend to track the performance of Government bonds. Citigroup Smith Barney predicts a 17% fall in the value of British water stocks if US bond yields rise 0.30% this year, so with that prospect now in sight, investors are understandably in a rush to bank profits.

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But is this the right thing to do? Maybe not, say analysts at JP Morgan. Yes, rising bond yields make the dividends offered by utilities less attractive, but given that the increase in UK bond yields has so far been only modest, the sell off is overdone. This is especially the case if bond yields persist in staying at higher levels than Ofwat has assumed for the next five years; if they do, the water regulator will very probably take that into account when it makes its next review of the sector's pricing. Note also that Ofwat has ensured that the revenue of the water companies grows on an annual basis at a real rate. Thus, assuming interest rates and bond yields are on the rise due to inflationary pressures (rather than better and better GDP growth), there should be faster nominal "top-line" growth than the one currently built into the bank's forecasts and hence higher nominal dividend yields than expected.That makes water stocks worth holding.