Higher interest rates create a number of risks and opportunities for investors in the utility sector.

Utilities have long been a staple for low risk income investors, such as those that live off dividends during retirement.

That’s because most utilities have long track records of highly secure and slowly growing dividends, thanks to their stable cash flows.

[ad#Google Adsense 336×280-IA]In fact, some utilities are even dividend aristocrats and dividend kings, meaning they have raised their dividends every year for 25 and 50 consecutive years, respectively.

In the past decade, however, record low interest rates have acted as a real growth tailwind, helping these stable electric, water, and gas companies borrow at ultralow interest rates.

In addition, yield-starved investors have turned to utilities such as Consolidated Edison (ED), Southern Company (SO), and Duke Energy (DUK) as high-quality bond alternatives.

With interest rates now rising and the pace of increases potentially set to accelerate in the coming years, many investors are worried about how utilities will do going forward.

Let’s take a look at how this industry is affected by higher interest rates, and why higher rates could pose several growth challenges.

Most importantly, find out how your own diversified dividend portfolio should be positioned in this new era of higher borrowing costs and rising yields.

Why Higher Interest Rates Matter to Utility Investors
Investor-owned utilities are unique in that they are essentially government approved monopolies.

In exchange for a high degree of government regulations regarding pricing, they are allowed a fixed rate of return on equity for the large capital investments they must make in order to construct and maintain their electrical, gas, or water infrastructure.

However, because they have this monopoly power, they also have a guaranteed and largely recession-proof source of very steady cash flow.

Dependable cash flow grants utility companies the ability to borrow large amounts of debt at relatively low interest rates (compared to other companies that have similar leverage ratios).

However, the flip side of this regulated monopoly business model is that the growth rate for utilities is generally pretty low. In fact, the majority of growth often comes from acquiring other utilities.

Much of the money for that comes from the equity markets, specifically in the form of issuing new shares in order to consolidate and grow into new markets.

For example, electric utility Wisconsin Energy Corporation (WEC) has used this equity capital approach to acquire numerous other utilities outside its home state of Wisconsin, as well as diversify into the natural gas business.

Similarly, Dominion Resources (D), one of the fastest growing utilities in America, has used equity issuances to fund numerous deals, including its $4.4 billion purchase of natural gas distributor Questar, as well as its $3.8 billion investment into the Cove Point liquefied natural gas or LNG export terminal.

And as you can see, between 1982 and 2016, when 10-year Treasury yields declined from 14% to just 1.36%, utilities have benefited from decreasing interest rates.

Lower interest rates for utilities not only means declining costs of borrowing, including refinancing previous debt at lower rates, but also a boost to their equity prices.

Source: Berkeley Labs

Utilities have benefited from lower interest rates because of the bond-like nature of their stocks.

More specifically, the lower interest rates are, the lower the discount rate investors apply to a utility’s future cash flow, resulting in a higher valuation the stock market is likely to give the stock price.

Think of it like this. Back in 1982 when you could have purchased risk-free Treasuries yielding 14%, the risk premium that investors were demanding from all stocks, even low-risk utilities, was much higher.

That’s because most utilities grow their dividends slowly, which means that there was little reason to pay a substantial premium for a utility stock when Treasuries were offering such high yields.

However, over the past three decades, as yields on risk-free investments have plunged, utility stocks suddenly offered higher and growing yields, making them far more appealing.

Now that interest rates are likely to rise by as much as 2.25% in the coming three or four years (according to the Federal Reserve’s latest rate outlook), investors could once more be able to get higher yields on Treasury bonds – potentially as much as 4%, 5%, or even 6% on 30 year T-bills.

The risk-free interest rate may end up even higher if Finance Secretary Steve Mnuchin gets his way and the U.S. starts issuing longer duration bonds, 50- or even 100-year Treasuries.

In other words, a key catalyst that has been driving investor capital into utilities (as well as other high-yield sectors such as Real Estate Investment Trusts and Master Limited Partnerships could be reversing.

As a result, share prices of most utilities could underperform the market or even fall, resulting in higher yields.

While that’s great for investors looking to put new money to work, it also means higher risks for those with a shorter time horizon

For example, some retirees’ portfolios aren’t large enough to purely live off dividend income, so they must periodically sell shares to pay for expenses.

It also means that the utility industry in general will likely face higher costs of capital, due to higher interest rates on new debt as well as lower valuations on share prices.

That could make it harder to find profitable growth opportunities with which to grow cash flow and thus their dividends.

Additionally, since the long-term total return for dividend growth stocks generally follows the formula dividend yield plus dividend growth, this could mean lower total returns for the sector going forward.

Future total returns could also be lower when you consider that the utilities sector trades at a forward P/E multiple of 17.9, which is 14% and 25% higher than its 5- and 10-year average multiples, respectively (according to FactSet data).

The Trump administration’s tax reform also poses a threat to one of the financial benefits of the utility industry. Specifically, the risk that the interest deduction will be eliminated in order to help pay for corporate tax rates to be lowered from 35% to 20%.

Utilities, because of their high debt loads, rely heavily on the ability to deduct their interest expenses, which helps lower their tax obligations and boost earnings.

In fact, according to an analysis by Bloomberg and Morgan Stanley, some utilities could face an earnings hit of as much as 8.5% if this provision of tax reform ends up becoming law.

Source: Morgan Stanley, Bloomberg

Also keep in mind that over the past few years a new kind of utility has become increasingly popular, specifically limited partnerships such as Brookfield Infrastructure Partners (BIP) and YieldCos such as 8Point3 Energy Partners (CAFD), NextEra Energy Partners (NEP), and Brookfield Renewable Partners (BEP).

These pass-through utilities are similar to MLPs in that the majority of cash flow is paid out as distributions, or a tax-deferred form of dividend.

However, while that means even higher yields than most traditional C-corp utilities, it also means that almost all of the growth capital for such utilities (which generally operate as solar, wind, and hydroelectric utilities) must come from external debt and equity markets.

Up until now, low interest rates have been a boon to such non-traditional utilities because of rock-bottom debt costs and high demand for their shares, courtesy of very fast dividend growth.

However, as interest rates rise over time, the risk for these utilities is that the one-two punch of higher debt costs and potentially lower share prices will make finding enough low-cost capital to keep growing at a rapid pace harder to come by.

Not All Utilities Are Equally Sensitive to Rising Interest Rates
While it’s true that utilities are likely to face stronger growth headwinds in the coming years, especially non-traditional utilities such as LPs and YieldCos, that doesn’t mean that there aren’t potentially great long-term opportunities in this sector.

After all, stocks are just ownership stakes in companies, and a company that can’t grow except in the face of record low interest rates is one that’s not worth owning. The key is to be selective and stick with just the highest quality utilities.

While practically all utilities are interest rate sensitive, due to the capital intensive nature of the industry, not all utilities will be equally negatively affected by higher interest rates.

For example, when it comes to traditional, C-corp utilities the most at risk are slow growing and highly indebted (relatively speaking) utilities such as Southern Company.

The reason for this is because the markets in which this utility operates (Alabama, Mississippi, and Georgia) are slower growing markets.

In addition, management’s recent attempts at spurring growth via big investments in clean coal and nuclear have resulted in large cost overruns caused by delays in project completion.

That has hurt the stock price, meaning that selling new shares to raise growth capital is less accretive to investors (due to higher dilution levels).

Southern Company’s dividend remains safe, but its low growth profile makes it more sensitive to interest rates than other utilities.

Other utilities that are likely to be more affected by higher rates include those in harsher regulatory environments, which result in weaker pricing power and lower returns on equity.

Pass-through entities such as LPs and YieldCos will be the most interest rate sensitive for two reasons.

First, the business model involves higher leverage ratios than traditional C-corp utilities, resulting in higher borrowing and refinancing costs in the future.

In addition, the need for higher equity dilution going forward will likely make these investments more volatile. That’s because access to cheap equity capital is based on the fickle nature of Wall Street.

However, well managed names such as Brookfield Infrastructure Partners (BIP) and NextEra Energy Partners (NEP) have both more conservative (i.e. safer) balance sheets and long track records of strong payout growth that has made both market darlings.

As a result, their yields generally remain between 4% to 6%, high enough to make distribution (and new capital) reinvestment worthwhile, but not so high as to raise the cost of equity capital to a level that stifles long-term growth.

On the other hand, you have poorly managed YieldCos such as Terraform Power (TERP).

Terraform’s previous general partner, SunEdison went debt crazy and wound up bankrupting itself and saddling Terraform with over $4 billion in debt (nearly three times its market cap).

This resulted in a sky-high leverage ratio (Debt / EBITDA) of 9.3. Terraform Power just barely survived filing for bankruptcy (and only after suspending its distribution entirely).

In contrast, diversified water utilities such as American Water Works (AWK) and Aqua America (WTR), both of which have managed to produce many years of healthy dividend growth courtesy of industry consolidation and more friendly regulatory environments, still trade at high enough premiums to raise plenty of equity capital at highly attractive rates.

In general, faster-growing utilities, such as Dominion Resources, will likely have easier times raising capital in the future, precisely because dividend growth investors are attracted to their faster payout growth.

Essentially, investors need to understand the underlying quality of the utility stocks they own. The best utility stocks in a higher interest rate environment are those that are able to gain regulatory approval to increase the rates they charge to customers.

This allows them to continue financing large construction projects at a healthy profit level. Other utilities, however, will have to absorb higher debt costs themselves if their customer base is unable to pay higher rates.

Fortunately, many of the best utility companies have been taking advantage of today’s low interest rates. They have invested in improving their infrastructure and refinanced higher interest rate debt.

Some have also used cheap debt to acquire businesses in non-regulated industries to gain exposure to faster-growing businesses, which could even make their businesses a bit less sensitive to interest rates.

How Utilities Fit Into Your Portfolio in a Higher Interest Rate Environment
In today’s market, where stocks are trading near all-time highs, it’s tempting to try to time the market.

Specifically, by using rising interest rates as an excuse to avoid utilities entirely, given the potential growth headwinds that rising rates may represent.

However, history has taught that such market timing is perhaps the worst thing you can do.

No one can predict the future and how certain types of investments will perform. Take the last major interest rate tightening cycle, for example.

The chart below show the dividend yield of the utilities sector (ticker XLU) in blue and the Federal Funds target rate in red.

You can see the last time the Fed really tightened interest rates was from 2004 through 2007, when the Fed Funds target rate increased from 1% to 5.25%.

The utility sector’s dividend yield stood at 4.7% shortly before the Fed’s tightening began in 2004. While the path wasn’t linear, the utility sector’s yield actually dropped to a low of 2.5% by 2007. Who would have guessed that would happen?

Source: Simply Safe Dividends, Federal Reserve

Today, the utility sector has a dividend yield of about 3.3%, which is much lower than where the sector’s yield stood when rates began increasing last time.

During the last tightening cycle, utility dividend yields topped out at 3.4%, which isn’t much higher than today’s average utility yield.

Simply put, it’s very hard to know what path utility stocks will actually take from here, even if interest rates increase meaningfully over the next five years.

The sector’s dividend yield has trended downward since 2009, but its current 3.3% dividend yield doesn’t strike me as being unreasonable compared to the last decade and historical interest rates.

It’s also interesting to note that the utilities sector actually outperformed the broader market during the last tightening cycle.

From 2004 to 2007 when rates increased from 1% to 5.25%, the utilities sector outperformed the S&P 500 in each of those years (the red bars exceeded the blue bars in the chart below).

Even despite their outperformance, utility stocks still meaningfully outperformed during the 2008 market crash.

Source: Simply Safe Dividends, Federal Reserve

So rather than avoiding utilities because of the potential for falling share prices, the most rational approach is simply to remain diversified across a number of sectors and be selective with the utility stocks you choose to hold.

Do your homework and choose the best names in the industry – those with solid, conservative, and long-term focused management teams. Make sure the balance sheet is safe and the dividend secured by a moderate payout ratio.

[ad#Google Adsense 336×280-IA]Most of all, don’t forget that the major reason for owning utilities is for generous and secure income.

Remembering that fact can help you become a better long-term investor and avoid getting chased out of quality stocks during periodic, unavoidable, and unpredictable corrections.

Also don’t forget that dividend reinvestment, when possible, is a key component to long-term success.

Which is why, unless you need the dividends to live on, a dividend reinvestment plan (DRIP) can be a great way to automate your portfolio and help you take the emotions out of your investing decisions.

By treating your diversified dividend growth portfolio like a cash flow focused business, one that owns a wide array of companies, including high-yield utilities, you are far more likely to reach your long-term financial goals.

Higher Interest Rates Could Mean Long-Term Buying Opportunities Ahead
While higher interest rates may result in some utilities facing additional growth headwinds, it’s important to keep things in perspective.

After all, like any good dividend growth stock, the best run utilities have proven track records of growing in any kind of economic and interest rate environment.

For example, utilities that are dividend aristocrats have grown their dividends even when interest rates were as high as 7%.

That being said, while the dividend payments from most utilities will likely remain safe in the coming years, the growth rates are likely to remain small.

And because of the bond-like qualities that many investors have valued in these stocks, higher interest rates could cause their share prices to underperform the market or even fall in the short-term.

However, long-term dividend investors stand to benefit. The key is to remain calm and remember that every correction, dip, or even share price crash is potentially a great long-term opportunity to add to your holdings, so long as their long-term outlooks remain intact and their dividends stay safe.

It’s also important to remember why interest rates are increasing. The Fed increases interest rates if it believes the economy is getting stronger and inflationary pressures are rising.

Higher economic activity means that consumers and businesses are in better health and, generally speaking, should be able to afford higher energy prices in many areas of the country.

So long as you own utilities that operate in regions with favorable regulation and maintain reasonable balance sheets, they should be positioned to pass on a good portion of their higher borrowing costs, protecting their earnings.

And don’t forget what happened during the last interest rate tightening period from 2004 through 2007. Utility stocks outperformed the market each year, and their dividend yields fell significantly.

The market moves in mysterious ways, but most utility stocks should continue providing stable income and reasonable downside protection for well diversified portfolios, even if they experience some near-term price volatility.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends