Until recently, utility stocks seemed like yesterday’s news.
Their days as bond substitutes looked numbered as interest rates climbed from ultralow levels. Their dividend yields—about 2.5% to 3% in recent times—seemed sure to be eclipsed by higher bond yields.
Then something happened: Bond yields failed to climb much. The yield on the benchmark 10-year Treasury briefly breached 3% in May but then eased off again. Investors gave utilities a second look and liked what they saw, driving the stocks up. Utility stocks in the S&P 500 have made gains of at least 2% in four straight weeks, a first for that sector. The previous record was three consecutive weeks in 2000 and 2004.
Utility stocks do look like an attractive place for yield hunters right now. With no sustained run-up in bond yields in sight, it’s a good time to selectively pick up some utility shares. Utility stocks have been sporting dividend yields of about 3.3% recently, well above the S&P 500’s average of 1.9%, providing investors with capital appreciation and income.
For many years, utilities were considered bond substitutes. Rates were at very low levels when the Federal Reserve’s quantitative-easing regimens were in place during and after the financial crisis of a decade ago. But as the 10-year U.S. Treasury yield climbed from about 2% last September to 3.1% this past spring, the utilities in the S&P 500 lost 9%. It was a stark illustration of what higher bond yields can do to utility shares, long a favorite of dividend investors.
But that funk, which saw these stocks fall nearly 4% in the first five months of the year while the market was up 1.2%, has given way to some bullish performance. Even with a dip of 1.7% this week, the stocks have returned 7.7% over the past month, tops among the S&P 500’s 11 sectors.
The risk of more competition from bond yields seems minimal for now. Jim McCaughan, CEO of Principal Global Investors, doesn’t see much inflationary pressure on the horizon, partly owing to the overall impact of technology. With lower inflation, there’s less pressure on yields to move up. Another potential lid on yields, he says, is the growing number of retiring baby boomers.
“There are a lot of people who are getting to where they want to use their assets, rather than accumulate their assets,” he says. “They want yield.” All of that could push up bond prices. (Bond prices and yields move in opposite directions.)
Utilities, McCaughan adds, would also be a relative haven if a trade war heats up.
There are some dissenters. Chris Verrone, head of technical strategy at Strategas, points out that utilities had a big selloff on Monday. The Utilities Select Sector SPDR fund (ticker: XLU) dropped 3.1% that day, a result attributed to the risk-on spigot getting turned back on amid hopes of a stronger economy. Verrone maintains that there are better places than utilities to invest for yield, notably the short end of the curve “without the principal risk.”
Still, utilities have some clear fans. In a note last month, Michael J. Wilson, chief equity strategist at Morgan Stanley, upgraded the sector to Overweight, partly on his expectation of “peak 10-year Treasury yields.” That yield was at 2.86% recently, unable to get back to 3%.
In a more recent note, on July 9, Wilson wrote that the market has started to rotate to a more defensive posture. Hence, the attractiveness of utilities and other defensive sectors, such as consumer staples and telecom, both of which were upgraded by Morgan Stanley earlier this month.
Wilson argues that three conditions are “typically necessary for a more sustained relative outperformance of the defensive sectors”—a peak in S&P 500 year-over-year earnings growth, 10-year Treasury yields topping out, and an inverted yield curve. That inversion hasn’t happened yet, but the spread between the two-year and 10-year Treasuries has narrowed, most recently to 0.28 percentage point, compared with one percentage point a year ago.
Wherever the 10-year yield goes, investors need to be selective about utility stocks.
Stephen Byrd, an equity analyst at Morgan Stanley, says that utilities generally can grow their earnings at a 4% to 6% annual clip and “sometimes quite a bit higher.” Throw in a nice dividend yield, and a high-single digit total return is within reach, especially if the earnings growth is durable.
“For years, utilities have done quite well on a risk-adjusted basis,” Byrd says. “They’re pretty reliable growers. The risk of an earnings miss is quite low.”
Utilities these days no longer hew to the model of a generation ago, when many were essentially local power companies. Renewable sources of energy, namely wind and solar, have taken on a much more important role.
Three such companies are American Electric Power (AEP), Xcel Energy (XEL), and NextEra Energy (NEE). Their respective dividend yields were recently 3.54%, 3.31%, and 2.64%.
NextEra operates Florida Power & Light, a large regulated utility in the Sunshine State, providing the parent company with stability. In addition, NextEra has become a powerhouse in wind and solar power, which it sells to utilities and other customers.
For NextEra and others in the wind space, “there are relatively high barriers to entry,” says Byrd. They are also supported by long-term contracts to distribute renewable power, and technological breakthroughs in wind power have helped a lot, too. “As these blades get longer, the output goes up exponentially,” he adds.
Based in Columbus, Ohio, American Electric Power has extensive wind and solar operations, and it’s investing in more. That includes the $4.5 billion that is being put into a huge wind-farm project in the western panhandle of Oklahoma.
Xcel Energy, based in Minneapolis, has a big presence in renewables as well, including wind-generation operations in Minnesota and elsewhere in the Midwest.
In upgrading the utility’s stock in February to Overweight, Byrd noted in part that the company “leverages low-cost wind to increase capital spending while driving customer bills lower and generating energy in a more sustainable way.”
