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Summary

  • Data for the late 1960s, late 1970s, and 2011-2014 indicate inverse association of 10-year Treasury Note changes and utilities stock prices.
  • Utility stocks and ETFs might see significant price declines if benchmark interest rates turn upwards sharply in the weeks ahead.
  • Bank of Montreal utility ETF, heavily weighted with oil and gas pipelines, may resist the downward price shifts.
  • The price of Enbridge held up well during the 2008 market crash, and has recently been twice as high as its 2007 peak.

Risk management challenge with utilities stocks

Are you enjoying a high yield haven with your utilities stocks or ETFs? If so, listen up; because it's time to think about risk management concerning the capital you have locked away in those instruments. Why?

The Federal Reserve has stepped up the reduction of its former bond-buying level. Everyone now awaits the rise of short-term interest rates, and the "smart money" is suggesting that the rise will be more rapid than most people expect. Such an interest rate increase will lower the demand for utility stocks and may threaten you with a capital loss.

The demand for utility stocks and ETFs heavily weighted with them would fall because a growing variety of instruments would be able to offer competitive yields. There is a further concern over the medium term with respect to those utility companies that may have to float bonds at interest rates higher than those of the bonds that they are retiring, once bond yields have moved to their usual historic levels.

Now here's the hard part for you if the prices you paid for your utility stocks or EPS are not far from their recent trading prices. If you need to sell the stocks at times over which you have little control, it will take only a modest capital loss to wipe out the benefits that you received from several recent dividend payments.

What are your risk management options here? Before addressing this question, I lay out below the case concerning the challenge that you may face from your holdings of utility stocks and ETFs if interest rates rise rapidly over the next several weeks.

Historical association of interest rates and utility stock prices

The tendency for interest rates and utility stock prices to move in opposing directions is not news. However, it is worthwhile to examine some of the pertinent evidence, using the charts that follow.

In these charts the United States interest rate indicator is the Federal Reserve Constant Maturity 10-year Treasury yield, which is available at the St. Louis Fed's FRED database. This indicator is represented by the blue curve in Charts 1 to 3.

Chart 1 shows that from June 1967 to April 1971 this indicator rate rose from 5% to nearly 8% and then fell back to close to 6%. During much of that period, there was a neat association of sharply rising interest rates with big falls in the Dow Jones Utilities Index. This you see on the left side of the chart. On the right side of the chart is a reverse pattern - declining interest rates went along with sharply rising utility stock index values. Although there is no direct causal linkage, good reasons for expecting this pattern of association can be found in the literature.

Chart 2 covers the famous period when 10-year bond yields rose well above 10% and stayed there for several months. This chart traces the pattern of the interest rate indicator from a level near 9% in late summer of 1979 to over 15% in late summer of 1981, and then back down to close to 9% by December of 1985.

Chart 2 shows an interesting divergence from the pattern of inverse association shown in Chart 1. During the time when the interest rates were rising markedly on the left side of the chart, we see the Dow Jones Utilities Index (DJU) trading mostly sideways. The DJU was not showing much of a response to the sharply rising interest rates! Moreover, from the fall of 1982 to about the middle of 1984, while the interest rate indicator rose from about 10% up to around 12%, the Dow Jones Utilities Index had a gentle up-trend curve for a good portion of the time. However, as we go into late 1984 and beyond, the expected association re-emerges, since a sharp fall in the interest rates was associated with a sharp rise in the Utilities Index.

This information might be the basis of a hope that as interest rates rise in the coming months, utility stocks and ETFs might, at worst, move sideways in their prices. Alas, Chart 3 seems not to support that hope.

In Chart 3, we come to the period from September 2011 to the end of July 2014. The blue curve once again is for the 10-year US Treasury yield indicator. We drop the DJU, and replace it with the SPDR utilities ETF (NYSEARCA:XLU), which is shown in the red curve. In this chart, in most cases when the blue curve (interest rates) shows a substantial fall, that of the ETF rises systematically. There is a lesser, but still notable, tendency for a rise in the interest rate indicator to be associated with a downturn of the utilities ETF.

The black curve in Chart 3 is for the Bank of Montreal utilities ETF ((TSE:ZWU)) , which began trading in January 2012. Among its holdings of mostly Canadian stocks, are well-known pipeline companies. If you want to take a position in the Canadian energy sector for longer-term capital gain (as world demand for energy grows) and do so via the pipelines, then the Bank of Montreal utilities ETF is particularly interesting. Over 20% of its holdings are in pipelines or other oil and gas-related companies. The BMO ETF seems less volatile than that of SPDR, but it has been out-performed, in terms of capital gain, by XLU from 2012 to 2014.

Thanks to the software built into the Yahoo Finance web site, we can quickly see comparative relative changes of both indicators. Chart 4 does this by using index numbers, with the number zero representing prices near the middle of 2012. This chart shows clearly that if you were interested mainly in capital gains, you would be much better off buying the SPDR ETF, since the BMO ETF spent a good deal of its time hovering around the zero level or below. However, it had a distinctly better dividend yield - generally just over 5% for ZWU, versus close to 3.5% for XLU.

The relatively weak performance of the Canadian ETF in capital gain is not a result of the pipeline stocks among its holdings. This is illustrated by Chart 5, which compares Enbridge (NYSE:ENB) with ZWU. Most of the other pipelines held by the BMO utilities ETF show roughly similar patterns of much sharper capital gains when compared to ZWU.

Looking at the charts of these Canadian pipeline stocks, from 2007 to 2014, one sees a striking picture that Chart 6 illustrates. These stocks' prices held up quite well during 2008, and broke down only during 2009. Also, that breakdown was short-lived. When we got well into 2010 the pipelines had gone above their 2007 peaks. Starting from above its 2007 peak, Enbridge's price doubled as of early summer 2014, reflecting an impressive confidence vote from investors.

In closing, it is worth noting something curious that has emerged with respect to the trading of utilities in the past very few weeks. They have turned down in price, and have done so without being led by a marked interest rate upturn. You can see the downturn reflected in some of the charts used here, but it is even more striking when you look at three-month price curves for several utilities at Yahoo Finance.

What is your best guess as to the meaning of this downturn in the prices of the utility stocks? Could it be that they reflect market-makers leading the way in pricing the expected interest-rate upturn into these stocks?

I believe that unless we are extremely lucky, those of us who are holding utility stocks and ETFs should not be surprised to see significant downward price drifts as the expected interest rate rises take place, if the latter are surprisingly sharp. Looking back all the way to the 1960s, the data suggest that these rates might not go up like a rocket. The degree of price pressure, therefore, will likely depend on how well the rate increases are well forecasted in advance by the market-makers.

In any event, surprises are common in the markets. Thus, the said price pressure could be great enough to threaten a negative result when aggregate capital losses in utilities are compared with the dividends they would have delivered. Consequently, some risk management thinking is in order.

Some would argue that if there are options associated with your holdings, you might consider buying protective puts that will expire after the dust settles on the interest rate rises. Any dividends that you get during in the near term could be used to help pay for options, on the grounds that the options will protect you against capita losses much larger than the received dividends. However, using options effectively will require that you are already experienced in options-trade adjustment.

If you do not have that experience, or if suitable options are not available, you will be left with the old-fashioned stop-loss order. Keep in mind, however, that price gaps in trading are common these days, and your stop orders may get filled at prices well below what you expect. This consideration supports the belief that ETFs are to be preferred over individual stock ownership, since the former are typically much less volatile.

Disclosure: I have a long position in the BMO utilities ETF, and the text above is my thinking about the said risk management issue. I am not a licensed investment advisor, nor is anything said above designed to be investment advice. I do not warrant correctness of the information provided above; but I have tried to be accurate in the descriptive comments. Do your own research to decide what, if anything, to do about your utility-stock positions as interest rates rise in the weeks ahead. 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.

Source: Canadian Pipelines May Offer A Haven If Utilities Slip Badly In The Weeks Ahead