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Investors See No End To High-Yield Utility Surge

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Despite red-hot performance over the last six months that might suggest it is time to lock in profits, a group of high-yield investors say there is still value in high-yield utility credits. In addition to offering attractive yields, investors say utilities should return to profitability on the heels of an improving economy and possible price increases from states. "Just because things have appreciated doesn't mean there is not good value there," saysShep Davis, who runs $3.5 billion in taxable fixed-income for ORIX Capital Markets in Dallas.

Utilities has been the top-performing high-yield sector year to date, outpacing telecommunications, the next-best performer, by more than 6%, according to Merrill Lynch data. Through last Tuesday, utilities have returned 39.13% for the year, versus 18.12% for high-yield overall. Despite that impressive run, utilities still offer better-than-average yield. The sector trades at 618 basis points above Treasuries versus 588 for junk as a whole.

Investors seem to have little doubt the sector will continue its winning ways.Penn Capital Management participated in last Thursday's $3 billion three-part bond and bank deal from Calpine Corp., as well as a recent $1.1 billion deal from Reliant Resources. Eric Green, senior portfolio manager and director of research at the New Jersey-based firm, still sees value in Aquila Inc.'s 11 7/8% notes of '12 (Caa1/B), which traded at 107 last Wednesday, and Edison Mission's 7.73% notes of '09 (B2/BB), which were bid at 85. He says Penn would still add to those names on weakness. He also likes AES Corp., which brought a bond deal in May and will be refinancing a bank deal later this month.

Some investors believe the sector is still a bargain because it is being shunned by portfolio managers who were burned badly last year. "The [high-yield] market's pretty picked over, and there are some people who probably don't ever want to invest in this sector again. The guy who sold these things at 18 is not going to buy them back at 95," says Brian Hessel, managing partner at Stonegate Capital. Further, he argues that historical recoveries on utility bonds are quite good if, contrary to his expectations, power markets do not improve and some companies file for bankruptcy.

In some instances, utility credits are beginning to change hands as distressed and single-B investors sell their improving credits to accounts with less tolerance for risk, notes ORIX's Davis. In addition to Calpine and AES, ORIX has recently been investing in CenterPoint Energy, and continues to like all three names. ORIX has also been eyeing the bonds of Mirant Corp., but is still not certain which part of the capital structure makes the most sense as an investment.

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