Investors got a big surprise yesterday when the Federal Reserve chose not to reduce its quantitative easing activity, keeping its current level of bond purchases intact. That move led to new record highs for the overall stock market and a big drop in bond yields.
But one of the biggest beneficiaries of yesterday's Fed decision was the utilities sector. With an eye toward figuring out why, let's take a closer look at utilities from two different perspectives to discover what made them respond particularly well to the prospects of continued quantitative easing.
Why investors like utilities
Utilities have a reputation for being dependable though unexciting businesses that produce predictable cash flow. To make up for their perceived lack of growth prospects, utility stocks have higher yields than most sectors of the stock market. For instance, the SPDR Select Utility ETF (NYSEMKT: XLU ) has a dividend yield of 3.8%, almost doubling the roughly 2% yield of the broader S&P 500.
Many individual utilities have even higher yields. On the electrical side of the business, giants Southern (NYSE: SO ) and Duke Energy (NYSE: DUK ) use their economies of scale to produce almost 5% payouts. Performance among gas utilities has been somewhat weaker lately, in light of relatively low natural-gas prices. But Atmos Energy (NYSE: ATO ) and Piedmont Natural Gas (NYSE: PNY ) both have healthy yields in the 3% to 4% range.
In addition to their high yields, many utilities also have long track records of raising their payouts over time. Atmos and Piedmont both have long streaks of annual dividend increases spanning 30 to 35 years. Duke and Southern don't have uninterrupted streaks of that length, but they nevertheless have rewarded shareholders with bigger payouts. Duke's dividend is up more than 50% in the past decade, while Southern has produced 150% growth in its payout since early 2001.
Yesterday's push from the Fed to produce lower bond rates made dividend-paying stocks look more attractive by comparison. That helped reverse a troubling trend among utility stocks in recent months, as share prices had generally fallen in order to keep dividend yields competitive with rising bond rates. Southern and Duke posted gains of around 3% to 3.5% yesterday alone, while Piedmont and Atmos ended up 2% to 3%.
Why utilities like lower rates
The other supporting factor for utilities from the Fed move yesterday affects utility-business fundamentals. More than many industries, utilities use substantial amounts of debt to finance capital-intensive projects like plant construction. In particular, with Duke, Southern, and other electrical utilities making major modifications to deemphasize coal in favor of natural gas, capital expenditures demand debt financing. Similar increases in demand for natural gas among residential and commercial customers can spark the need for greater spending from gas utilities. As a result, debt-to-equity ratios for all four of the companies mentioned above are greater than 100%.
Substantial debt makes low rates important. In a rising rate environment, utilities have to refinance maturing debt with more expensive new debt, raising debt-financing costs and depressing net income. A slower pace of rate increases, however, sparked hope that utilities could sustain their low interest costs longer than expected.
Will the good times last?
Unfortunately, the positive reaction yesterday for utilities could prove short-lived. Although the Fed didn't change its monetary policy yesterday, it also didn't change its views that it will eventually have to reduce its QE spending. When that happens, utilities could once again see downward pressure on their share prices. For now, though, utilities are enjoying the prospect that their day of reckoning might be further away than they had feared.
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