A frequently cited investing adage is to avoid utility stocks in times of rising interest rates. That's because high-yielding securities like utilities are often used as income generators when bond yields are low. Once yields begin to rise, many investors make the switch from equities to bonds. However, this move might not always be wise.
It's reasonable to become wary of utility stocks like American Electric Power (NYSE:AEP), Consolidated Edison (NYSE:ED), and Duke Energy (NYSE:DUK) because their share prices languished last year while the broader market roared higher. And, since their capital structures are heavily reliant on debt financing, rising interest rates could make it difficult to refinance their debt at manageable costs going forward.
It's true that investors looking for outsized capital gains in the midst of a full-fledged bull market should look elsewhere. But from an income perspective, which is probably the primary reason for buying utilities in the first place, you shouldn't be discouraged. The fat dividend yields these utilities offer aren't in danger when interest rates rise, for the fundamental reason that their businesses are strong.
Remember that utility stocks are not bonds
It's true that utility stocks seem to trade like bonds, sometimes. In periods of raging bull markets, utilities will often under-perform. This is especially true if a bull market coincides with rising interest rates.
That's why utility stocks effectively sat out the broader market rally in 2013. While the S&P 500 Index rose almost 30% including dividends last year, the utility sector under-performed. However, it's important to know that from a purely income perspective, utility stocks did exactly what they always do. They kept paying their hefty dividends, and many actually raised their dividends last year, even as interest rates rose.
That's the fundamental difference between bonds and stocks. Bonds are a fixed income security, meaning their interest payments are contractually set. On the other hand, dividend-paying stocks such as utilities are pass-through entities. Their profits and dividends still have the potential of going up, even if interest rates rise.
Earnings and dividends still going in the right direction
American Electric Power grew operating profit by 4.5% last year, and both American Electric Power and Duke Energy guide their investors to expect long-term earnings growth of between 4%-6% annually. In 2013, Duke Energy and Consolidated Edison posted adjusted earnings growth of approximately 1% and 1.3%, respectively.
In this regard, rising interest rates may not be such a bad thing from a fundamental perspective. Rising rates are often symptomatic of an improving economy, which bodes well for stocks more broadly. Utilities will benefit from increased economic growth in the United States, as it would leave open the possibility for greater rate increases and transmission growth. In fact, in their recent investor presentations, American Electric Power and Duke Energy specifically cite improved economic growth as a fundamental driver of their long-term earnings growth targets.
Low-to-mid single digit earnings growth isn't hugely impressive by any means, but to be fair, growth is still growth. And, earnings growth will translate into dividend growth, which is what separates dividend stocks from fixed income securities. Each of these three utility stocks increased their dividends last year. In fact, American Electric Power increased its payout twice.
The Foolish takeaway
While utility stocks may trade like bonds when interest rates rise and see their share prices under-perform during roaring markets, a distinction should be made between utility stocks and fixed income securities. Bonds are contractual obligations with a set interest payment, while stocks are pass-through securities. It's important to remember that stocks, including utilities, will benefit from an improving economy.
It's true that utility stocks can't be counted on for huge capital gains, particularly when interest rates are going up. But from an income perspective, which is presumably why most investors buy utilities in the first place, there's little reason to worry. American Electric, Duke, and Consolidated Edison should see profits rise when the economy improves, which will allow for future dividend increases as well.
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