The utilities sector has often been considered a “widows & orphans” group of stocks, with a long history of paying healthy and reliable dividends that makes these stocks safe enough for even the most conservative investors. Since the beginning of the summer, these shares have declined significantly — but even at discount prices, they still have serious risks.
The great capital rotation
To understand the current dynamics for this basket of stocks, we first have to take a look at what has happened to the group over the last several years. Utility stocks have been popular because of the high dividend yields paid by the individual companies.
For example, Duke Energy Corp (NYSE:DUK) pays an annual dividend yield of 4.5%. The Southern Company (NYSE:SO) currently pays investors 4.6%, and Dominion Resources, Inc. (NYSE:D) has a 4% dividend yield. These are three of the largest stocks in the Utilities Select Sector SPDR – an exchange traded fund that tracks the utilities sector.
In an effort to stimulate the US economy, the Federal Reserve has reduced target interest rates to extremely low levels. The Fed has also been aggressively buying Treasury securities, along with mortgage-backed securities. This has had the effect of driving bond prices higher across the board, and sending interest rates sharply lower.
Why does this matter for utilities stocks? Well, with Treasury bond prices extremely high (and corresponding interest rates extremely low), a large portion of “safe” investors have been forced to find other areas to park their capital.
Investors in need of income have sold low-yielding treasuries and mortgage backed securities, and rotated their capital into stocks with high dividend yields. This capital rotation has pushed dividend-paying stocks steadily higher, causing valuations to rise materially over the last four years (see chart below).
Over the past few weeks, investors have begun fretting about how and when the Fed will start reducing its massive bond buying program. The most recent Fed announcement indicated that these bond purchases will likely be slowing over the next few months, which will reduce the overall demand for Treasury and mortgage bonds.
Interest rates are already starting to increase, and the effects are being felt in the broad economy. Last week I noted that rising mortgage rates were creating challenges for homebuilders.
As rates increase, conservative investors have an incentive to move their capital back into “safe” areas such as Treasury bonds and mortgage backed securities. This is especially true as volatility picks up in the stock market. As this safe capital flows out of dividend paying stocks, and into bond securities with more attractive yields, the utilities sector is vulnerable to further price declines.
No earnings growth
It is important to note that while stock prices for utilities have increased over the past several years (along with valuations as we saw in the chart above), actual earnings levels for these stocks has not changed much.
