Utility stocks pay some of the safest dividends around and typically sport much higher dividend yields than the market, reflecting their low growth prospects and making them a favorite source of income for retirees living off dividends. Many dividend investors wonder if utility stocks are in a bubble today after benefiting from extremely low interest rates for more than six years. Utilities were clobbered on Friday after strong employment data strengthened the likelihood that the Fed would raise interest rates next month for the first time since mid-2006.
The fear is that many investors flooded into higher yielding stocks like utilities because they could not earn enough safe income from the very low yields bonds offer today (see below). Once bond yields begin to rise as the Fed gradually raises its target interest rate, these investors might sell their stocks to purchase bonds.
Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis
As seen below, we have been living in unprecedented times over the last seven years, with the Fed’s target interest rate remaining just above zero percent. It has never been this low for this long before, so there is plenty of uncertainty regarding how an eventual interest rate increase, as early as December, will impact markets and yield-sensitive sectors like utilities. Have these safe haven sectors been artificially inflated by the Fed’s easy money policy? Will they pop when interest rates begin to rise?
Many dividend investors are clearly worried. On Friday, November 6th, a strong US payroll report came out. The Fed watches employment figures and inflation to determine its stance on interest rates, and the strong jobs report signaled that a rate hike in December was now almost a certainty. This would be the first rate increase since 2006.
Immediately, many dividend aristocrats and utilities sold off hard. The XLU utility ETF finished the day down more than 3.5% despite the S&P 500 finishing about flat. Clearly the knee-jerk interest rate trade is to sell higher yielding, slower growing companies like utilities in favor of interest rate beneficiaries like banks (the Financials sector was the strongest performer on Friday) and more cyclical growth companies that would benefit the most from an improving economy.
Before diving into utilities in particular, let’s take a step back and look at the S&P 500’s dividend yield relative to its history and the Federal Funds Target Rate.
As seen below, the S&P 500’s dividend yield sits just below 2% today compared to the Federal Funds Target Rate of 0.25%. If we were living in a dividend stock bubble that could be popped by rising interest rates over the next few years, we would expect the market’s dividend yield over the past several years to be extremely low relative to history.
However, this is clearly not the case. The last time interest rates were exceptionally low was during 2003 when they sat at 1% for several quarters before tightening significantly to 5.25%. During 2003, the market’s dividend yield hovered around 1.5%, 25% lower than today’s dividend yield. We can also see the market’s extreme euphoria during the tech bubble when the S&P 500’s dividend yield dipped to 0.98%, half of today’s yield.
Perhaps most interesting is the period from 2004 through mid-2006 when the Fed tightened interest rates from 1% to 5.25%. The market’s dividend yield increased around 20%, from 1.5% to 1.8%, but both of these yields are still lower than the market’s yield today.
While certain parts of the market are likely more vulnerable than others during a period marked by rising rates, the entire class of dividend paying stocks does not appear bubbly relative to the last 20+ years of market data that we can observe, especially relative to current interest rates.
What about the utilities sector? The Conservative Retirees dividend portfolio we oversee has meaningful exposure to utilities and REITs. As you can imagine, Friday wasn’t a great day.
While we don’t lose any sleep over our holdings’ abilities to continue paying and growing their dividend payments, we remain mindful of the portfolio’s overall total return potential (income and price return) and continuously look to minimize our downside risk. If utilities and REITs are in a bubble, we should seek returns elsewhere until conditions normalize as a result of rising interest rates.
The chart below compares the annual total return of the S&P 500 (blue bars) and the Utilities sector (red bars). The Federal Funds Target Rate (green line) is also displayed to highlight periods of rising and falling rates. Many investors are quick to assume that higher yielding dividend stocks like utilities will be major underperformers over the next five years as interest rates gradually rise.
However, we can see that during the last period of rising rates, from 2004 to 2006 when rates increased from 1% to 5.25%, the utilities sector actually outperformed the S&P 500 in each of those years! Despite four straight years of outperformance relative to the market during 2004-2007, utility stocks still significantly outperformed during the 2008 market crash.
2014 was a huge year for the utilities sector, which returned about 30% and easily outpaced the market. Many investors have predicted higher interest rates in each of the past few years, but the Fed has continued delaying, helping utility stocks outperform. However, December 2015 could finally vindicate those expecting higher rates.
Not surprisingly, the chart above also shows that utility stocks have return -8.1% YTD, significantly trailing the market’s 3.7% return and reflecting investors’ expectations for a rate hike next month.
With rates looking set to move higher, will utility stocks need to meaningfully drop in value to keep their dividend yields relatively attractive for investors? While we can’t predict the future, we can compare the dividend yield of utility stocks today to their yield throughout history.
The chart below does just that while overlaying the Federal Funds Target Rate (red line). Utility stocks, as represented by the XLU ETF, closed Friday with a dividend yield of 3.7%. This yield is higher than the 3.4% yield utility stocks had in 2003 when interest rates were 1%, and it’s also higher than the 3.4% yield utility stocks topped out at in 2006 when rates peaked out at 5.25%.
The utility sector’s dividend yield has been in a downward trend since 2009, but its current yield appears quite reasonable relative to the last decade and historical interest rates. Once again, we don’t see signs of a bubble here despite Friday’s price shock.
Finally, we compared the Utility sector’s dividend yield to the S&P 500’s dividend yield over the last decade. The chart below shows the difference between the two yields. A figure of 2% would mean that the Utility sector’s dividend yield was 200 basis points higher than the S&P 500’s yield (e.g. 5% yield compared to a 3% yield). A lower yield gap suggests that utility stocks could be expensive relative to the market.
While the yield premium has come down meaningfully since peaking out at 2.4% in early 2011, its current reading is about in line with where it traded prior to the rate increases that occurred from 2004 through mid-2006. Interestingly, the yield premium fell during this time as utility stocks outperformed the market. Unless cyclical growth stocks really take off and leave utility stocks behind, it’s hard to imagine the yield premium returning to 2.4%.
How Interest Rates Actually Impact Utility Stocks
Beyond historical dividend yields and interest rates, remaining focused on companies’ fundamentals is the key to long-term investing success. For this reason, it is important to understand why interest rates are very important to utilities’ actual businesses (not just fickle investor sentiment).
First, utilities maintain extremely large debt loads. Constructing and maintaining power plants and infrastructure to deliver electricity and gas are extremely costly activities. The stable cash flows generated by utilities alleviate some of their credit risk, but the regulatory environment in each operating region plays a big role in a utility company’s health.
Some companies are able to gain regulatory approval to increase the rates charged to customers to finance the large construction projects and higher borrowing costs they undertake, while others must absorb more of these costs themselves if customers cannot afford higher rates, lowering earnings. Many utilities have benefited from lower interest rates over the last 5+ years, allowing them to cheaply improve their infrastructure and refinance high interest rate debt to improve cash flow generation.
Improved cash flow and the lower cost of debt has also enabled some utilities to acquire businesses in non-regulated industries to gain exposure to faster-growing businesses over the past few years, perhaps reducing the sensitivity of their businesses to interest rates.
While rising rates make other yield investments relatively more attractive and could gradually increase utilities’ borrowing costs, it is important to remember why interest rates generally rise in the first place.
The Fed will only raise rates if it believes the US economy is strengthening and inflationary pressures are gaining steam. In such an environment, consumers are doing well and are more able to afford higher energy prices.
For utilities operating in regions with favorable regulation, this means they have a greater ability to pass on their higher borrowing costs resulting onto consumers through higher energy bills, protecting and growing earnings.
As we previously showed, during the last tightening period from 2004 through 2006, utility stocks actually outperformed the market in each year! It’s far from a certainty that rising rates over the next few years will be worse for utilities than the rest of the stock market.
So, Are Utility Stocks in a Bubble?
While the plunge in higher yielding, slower growing companies such as utilities was painful on Friday, it is important to keep the big picture in perspective and remain resistant to swings in market sentiment.
Given the world’s fragile state, the Fed seems likely to very gradually raise interest rates, assuming it does indeed start to act in December. Whether rates rise or fall, owning a portfolio of reasonably priced companies that earn solid returns on capital and grow their cash flow (and dividends) over long periods of time will always be a winning strategy. That is what we try to do with our Top 20 Dividend Stocks portfolio, which includes several REITs and utilities.
From a historical point of view, dividend stocks do not appear to be in a bubble, but they could decline in the initial months surrounding an interest rate increase like they have in the past. Utilities’ dividend yields also appear reasonable, and these stocks actually outperformed the market during the last period of rising rates from 2004 through 2006.
While anything can happen and we are coming off of an unprecedented period of low interest rates, we do not see a bubble today and believe that most utility stocks will continue providing stable income and reasonable downside protection for many portfolios, even if they continue experiencing near-term price volatility.