Citing 2002 in worry that rising rates threaten utility stocks

Timothy O'Brien, manager of the top-performing Evergreen Utility and Telecommunications Fund, said utility stocks might extend a monthlong slump as interest rates increase after rising to an all-time high.

"I'm worried about the bond market," O'Brien, 52, said in an interview in Boston. "Given the correlation between yields and utility stock prices, now you have to dust off the playbook from 2002."

The Philadelphia Utility Index has dropped 8.9 percent from a May 16 record after 10-year Treasury yields rose to a five-year high. Increasing rates hurt utility stocks by making their dividends less attractive than bonds. The index had tripled after falling to an eight-year low in October 2002, reached after Enron Corp.'s bankruptcy soured investors on the industry.

O'Brien said he configured the mutual fund so two-thirds of its holdings had little sensitivity to interest rates. They include energy companies Southwestern Energy Co. and Williams Partners L.P., whose earnings are closely tied to natural-gas prices, which have risen an average of 18 percent a year since June 2002. He also added telephone and international stocks and has more of the fund's assets in cash than he usually does.

The $755 million Utility and Telecommunications Fund, run for Evergreen Investments by O'Brien's Crow Point Partners L.L.C., of Scituate, Mass., has returned 17.3 percent this year, ranking second among 23 similar funds tracked by Bloomberg, after the MFS Utilities Fund, which gained 17.6 percent. Evergreen climbed an annual average of 22 percent during the last five years, placing third after the MFS and Jennison Utility funds.

Ten-year note yields have increased as much as 38 basis points this month to 5.27 percent on speculation that accelerating economic growth may keep the Federal Reserve from lowering rates in 2007. A basis point is one-hundredth of a percent. Investors buy utilities for steady earnings and dividends when the economy weakens.

Southwestern Energy, which drills for gas in Arkansas and Texas, and Williams Partners, the largest U.S. pipeline company, have been more resistant to a utilities slump. Shares of Houston-based Southwestern have risen 8.6 percent since May 16, and stock of Williams, based in Tulsa, Okla., has fallen 1 percent.

At the same time, the Evergreen fund's biggest utility holdings have sunk. Shares of Public Service Enterprise Group Inc., based in Newark, N.J., the third-biggest investment, have declined 8.6 percent, paring this year's gain to 27 percent. Baltimore-based Constellation Energy Group Inc., the No. 5 holding, has dropped 8.7 percent, leaving a return of 24 percent in 2007.

The fund has a Sharpe ratio of 2.73, higher than the 2.48 average of its peers, according to research firm Morningstar Inc., of Chicago. The higher the ratio, the better the risk-adjusted returns. It gets four out of a possible five stars from Morningstar.

O'Brien, who has a master's degree in business from the Wharton School of the University of Pennsylvania, has set himself apart by investing 32 percent of the fund in telephone and wireless stocks, compared with 18 percent for his peers, according to Morningstar. The manager said phone shares, which some other utility-fund managers divested after U.S. deregulation two decades ago, diversify his commodities-dependent utilities.

The Evergreen fund's biggest investment is San Antonio, Texas-based AT&T Inc., whose stock has risen 9.3 percent this year. It surged 46 percent in 2006, when AT&T bought BellSouth Corp. for $86 billion in the U.S. phone industry's largest takeover. New York-based Verizon Communications Inc., the No. 6 position in the fund, has gained 16 percent this year. It increased 28 percent in 2006.

Ralph Acampora, director of technical analysis at Knight Capital Group Inc., of New York, said in an interview that large-company shares such as AT&T might lead the stock market, in part, because the company can withstand higher interest rates. The stock may rise to more than $50 in as little as a year from about $39 today, he said.

The Evergreen fund last year increased its limit on foreign holdings to 30 percent from 10 percent as international stocks outperformed those in the United States. O'Brien said power consumption was rising faster in Europe, boosting prices at Dusseldorf-based E.ON AG, Germany's largest utility, and Essen-based RWE AG, the second-biggest.

Profit at both companies jumped 50 percent in the first quarter. E.ON's stock has climbed 37 percent in the last year, and RWE's advanced 26 percent.

"Europeans are catching on to things that we like here," O'Brien said, "such as air-conditioning."

Fund manager: Timothy O'Brien.

Assets: $755 million.

Performance: Up 17.3 percent this year.

Significant holdings: AT&T Inc., TXU Corp., Verizon Communications Inc.

Ticker: EVUAX.

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