As interest rates remain at historically low levels, bond investors search for alternatives that provide decent yields without taking on excessive risk. For some, that’s meantthis means switching into common stocks, at least in firms that pay high dividends and operate in less volatile parts of the market, like the public utilities sector.

Of course, even these presumably safe and stodgy stocks still carry considerable risk, since, unlike a bond, no stock ever involves repayment of principle. Yet, the last two years have shown that bonds are also riskier than was formerly perceived. The spectacular failure of Lehman Brothers and AIG may have been isolated cases, but many other companies have had their bonds downgraded amidst ongoing credit concerns. Even municipal bonds, which traditionally have tiny default rates, have come under increased scrutiny as state and local pension obligations increase while tax revenues decline. Both Moody’s and Standard and Poor have repeatedly lowered the credit rating of large states including California, New York, and Illinois.

In addition, there is interest rate risk. If rates climb dramatically in the next two or three years, bonds with longer maturities will have a lower market value. This may not concern buyers of individual bonds who plan to hold them to maturity, but for investors in bond funds, which trade in and out of the market, rising rates can result in capital loss.

With these scenarios in mind, an investor might ask, “if ATT—to pick a random example—is paying nearly a 7 percent dividend, isn’t that a wiser investment than the municipal bonds of some small school district in the Central Valley? Even though interest on the municipal bond is tax exempt, the after-tax yield on the stock will still be higher, and perhaps safer.” As more investors pursue this theme, the common stocks of various utilities are getting a second look.

Why utilities—as opposed to dividend-paying stocks in less regulated, higher growth industries? Well, several other sectors that have typically paid high dividends have lost some luster. The banking industry, for example, is littered with marquee names that have slashed dividends in order to meet capital requirements. Pharmaceutical companies, also traditionally rich dividend payers, must now navigate the new, increasingly regulated healthcare landscape. Besides, as both banks and big pharmaceuticals come under greater government supervision, there is an argument for preferring investments in a sector that already has lengthy experience in dealing with government regulators. Utilities have been heavily regulated almost since birth.

So, how do you pick sound utility stocks? Since the main objective is yield with reasonable safety, a good starting point is to use criteria that apply to any dividend oriented investment. First, look for a long record of steady, and growing, dividend payments, with a payout ratio (the ratio of dividends to earnings) that’s low enough to be sustainable, and a debt-to-equity ratio that’s low enough to provide a cushion against a period of unexpectedly lowered earnings. Next, seek companies with a decent return on equity, since this is a good indication of management’s efficiency. A screen of large utilities based on these criteria might show names such as: Consolidated Edison, Dominion Resources, Excelon, and the Southern Company. As always, such screens should be considered starting points for further investigation, perhaps with the assistance of a financial advisor.

Unfortunately, finding competent assistance in choosing utilities isn’t easy. Because this is such an unglamorous market sector, few professionals find it worth their while to try to add value to the stock selection process. For the broker who predicted the renaissance of Apple Computer when Steve Jobs returned in l997, the result was a stock appreciation in thirteen years of more than 2000 percent. Jackpots like this induce analysts to spend lots of time looking for another Apple, Google, or eBay. But no one looks for the next Consolidated Edison.

Yet, even without personalized professional advice, a diligent investor can study information sources like Value Line, Standard and Poor, Bloomberg, and Barron’s. The regulatory climate of a particular state needs to be examined—is it investor friendly? The demographics of the customer base must be analyzed—is the market area growing or shrinking? The utility’s management has to be judged—is it forward looking, and willing to invest in renewable energy where feasible? Is it ahead of the curve in implanting new technology? Is it adept at maintaining good customer and political relations?

Because utility shares have little volatility, it is tempting to think of them as “one-decision” stocks, to be purchased and put away. Nine years ago, shareholders in PG&E learned how bad an idea that was. Trapped in a bizarre regulatory climate whereby the company had to pay more for power than it could recoup in rates, PG&E went into bankruptcy. The company has since been successfully resuscitated, but those who decided to bail out of their shares at the low point in July of 2002 have found scant comfort in that.

So, is the nonprofessional investor better off putting money into several carefully chosen utility funds (either managed or indexed) rather than into individual stocks? Perhaps, but the case for seeking diversification through funds is not as compelling as in less regulated market sectors. With utilities, there is less chance that a company will blow up entirely—after all, even PG&E’s shareholders didn’t get wiped out, they merely lost their dividends for awhile.

Nevertheless, there are many funds that focus on the utilities sector and are managed by well known mutual fund companies like Invesco, Putnam, and Van Kampen. Mario Gabelli, a frequent member on Barron’s semiannual financial forecasting panel, has also carved out a niche in utilities with several strong performing funds, but they carry high expense ratios. Another approach is to use funds that simply track utility indexes. Their fees are lower, and they offer wide diversification. However, the indexes include many less regulated utilities (often called “merchant utilities”) so the investment may not be quite as conservative as intended.

Any discussion of dividend yield should mention the likely change in the income tax law next year. Most dividends are now taxed at the rate of 15 percent, but it appears likely that this will rise to 20 percent or higher. Nevertheless, utilities’ conservative nature retains appeal; in good times or bad, people still need heat, light, and water. Since most utility companies operate as quasi-monopolies, they have little to fear from competition. Utility investors don’t expect to hit home runs, but they reduce their danger of striking out.

Steve Stein devotes his time to money management and financial reporting. His work has appeared in the (Hearst) Examiner and the Fort Lauderdale Sun Sentinel.