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Don't Pull the Plug on Utilities

With interest rates rising again lately, it's time to check the meter on utility funds.

Once the humdrum investing province of widows and orphans, utilities surged in popularity last year as their generous dividends -- now taxed at only 15%, per the president's 2003 tax cut -- gave investors of all stripes a welcome alternative to low-yielding Treasuries.

Utility companies, which are traditionally big corporate borrowers, also benefited from historically low long-term rates in 2004, surprising a number of fund managers who had expected higher rates to keep a lid on utility share prices. As a result, the average utility fund rose a nifty 21.6% for 2004, trailing only energy funds, according to fund tracker Morningstar.

"A lot of people expected last year to be weaker on account of rising Treasury yields, but that turned out not to be the case at all," says Morningstar utility fund analyst David Kathman.

Utilities' strong run is all the more astonishing since it comes in the face of the Federal Reserve's best efforts to stem inflation by raising rates. Fed Chairman Alan Greenspan has lifted the overnight lending rate six times since last June, and most market analysts predict he and his merry band aren't done yet. In his most recent testimony to Congress, Greenspan admitted he was stumped by the stability in long-term rates, calling their failure to rise a "conundrum."

The Maestro may be lacking an explanation, but utility fund shareholders are seeing firsthand how devastating rising rates can be on their investment.

When a higher than expected core producer price index was announced last week, the fear of inflation caused the yield on the benchmark 10-year Treasury bond to jump 8 basis points to 4.26%. The rise in yields promptly led to heavy selling in utility shares, as evidenced by a 1.1% drop in the iShares Dow Jones U.S. Utilities Sector (IDU) exchange-traded fund, which tracks the sector.

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