Utility Sector May Lose Its Power Over Investors

Rising market interest rates are giving utility stock holders something they have not had for a long time: a choice. What they need to know now is whether it's the right one.

Utility stocks were the only game in town for yield-hungry investors. With market interest rates at record lows, investors desperate for income streamed into utility stocks, sending the Dow Jones Utility Index up over 30% since April 2003.

The rise in the 10-year Treasury yield from a March low of 3.65 to its current level near 4.38%, however, has given utility investors a long-awaited opportunity to switch to bonds. The allure of higher yields has already knocked the utilities index from its one-year high of 283.47 on April 2 -- which happens to be the date of the blowout April jobs report -- down to 272.34.

Utility investors might be able to withstand a minor selloff while the Fed remains patient in deciding when and how much it will raise short-term rates. But what would really scare them would be a repeat of the 1994-95 period when the central bank doubled its overnight lending rate, trigering a 33% plunge in the Dow Jones Utility Index.

So for utility investors on the edge, considering jumping ship, here's a breakdown of the utility sector with some points you might want to consider before making a leap to Treasuries.

Water, Water Everywhere

Water utilities typically offer slightly lower dividend yields than electricity providers and natural gas distributors. And with bond yields on the rise, one might think it would put them at a comparative disadvantage to other, higher-yielding utility categories.

But that particular theory doesn't hold water, says David Schanzer, analyst for Janney Montgomery Scott. According to Schanzer, the water utility industry has the advantage of being able to increase its dividend payout rate to keep pace with rising interest rates, while other, more highly leveraged utilities such as electricity providers might be tapped out when it comes time for a dividend hike.