What Will Happen To Utility Stocks If The Fed Raises Rates?

Robert Howard, CFA profile picture
Robert Howard, CFA
408 Followers

Summary

  • Relative to the yield on the 10-year Treasury, utilities actually look cheap today.
  • Based on earnings, however, they look expensive.
  • The decline in utility prices so far this year is likely the market preparing for a rate increase.
  • If rates do go up, the worst of the damage has likely already been done; and there won’t be a large amount of additional downside.

Utilities are often thought of as a "bond substitute". They have fairly steady earnings and usually have regulatory support to keep them healthy. Investors often think of utility dividends as a revenue source comparable to a bond's interest payment. Ever since 2008's financial crisis, utility valuations have been influenced by the artificially low interest rate environment the Fed created. Since the returns available from bonds have been so terrible, investors have naturally moved to utility stocks as a way to increase their income. As the Fed discusses the possibility of higher rates, investors should think about the implications for their utility holdings.

You can really see how interest rates have impacted utility stocks (as measured by the Philadelphia Utility Index (UTY) since 2014 in the following chart.

Chart 1

Source: FactSet

In 2014, while interest rates were falling, all stocks were basically rising (as shown by the S&P 500), but the utilities seemed to be receiving an added boost. Utilities peaked early this year, and since then, as Treasury yields have risen, they have taken a fall much greater than the rest of the market. A large amount of the utility drop is likely from investors anticipating a Fed rate increase and trying to get out before a big fall.

Expanding this chart to the turn of the century provides additional observations.

Chart 2

Source: FactSet

First off, you can see that utility dividend yields were lower than the 10-year treasury essentially until late 2002. At that point Enron, the California Electricity Crisis, and unwise investments by many players in the industry, finally took its toll, and utility values crashed. The yield on the 10-year treasury was actually falling because of the recession, but utilities performed terribly even with their "safe haven" status. Then over the next few years, as 10-year Treasury rates rose, utilities actually performed well. Utility dividend yields again were below

This article was written by

Robert Howard, CFA profile picture
408 Followers
Rob Howard is Co-Manager at Boiling Point Resources. Rob has extensive background in the utility industry working at Baltimore Gas and Electric for over seven years. While there he spent time in Distribution Engineering, Demand Side Management, and Rates and Regulation. This hands on experience has given him a deep understanding of industry issues. After his industry experience Rob moved to the investments business, where he has been following utilities since 2002. Rob has a BS in Engineering and a BA in Economics from Swarthmore College. He has an MBA in Finance from The University of Texas. He is also a CFA charterholder.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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