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 EverywhereWater 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.
And if rates remain at the current levels until well past the presidential election? Schanzer insists the consolidation in the industry will sustain continued growth, especially from companies such as Aqua America ( WTR) (yield 2.34%), Consolidated Water ( CWCO) (yield 2.28%) and Artesian Resources ( ARTNA) (yield 2.9%).
Electric Power GeneratorsDouglas Fischer, electric power utilities analyst at AG Edwards, recommends investors take "a cautious and selective approach toward the group reflecting fair to full valuations and the prospect of rising rates." But if the upcoming economic data -- especially when it comes to nonfarm payroll and jobless figures -- are not strong enough to convince the Fed to raise the overnight lending rate before November's election, then utility investors might want to stay put for a while in a less economically sensitive area of the stock market. During periods of economic growth, investors tend to turn to tech and other sectors that are leveraged to a growing economy. Utilities, on the other hand, are far from leveraged to the market, because demand for electric power does not fall drastically on the basis of economic conditions. Nevertheless, just because energy use remains steady, that doesn't mean dividends can't be cut. That has been a widespread occurrence over the last two years, after some electric utilities (such as TXU ( TXU) and American Electric Power ( AEP)) overstepped their boundaries by expanding into Europe and elsewhere, with disastrous results. When it comes to a safe dividend yield, David Peltier, author of TheStreet.com's SaveSafe product, says Con Edison ( ED) is the "iron man" of electric utilities, having raised its dividend 29 consecutive years. The company's 5.3% yield is also the highest in the regulated energy utility business as well as the Dow Jones Utility Index. "Con Ed can comfortably cover its dividend payment with annual earnings, and its debt is A-rated by all of the major credit agencies," says Peltier. "This streak has survived through the early 1980s, when the fed funds rate was in the double digits for three years straight; it has outlasted wars and blackouts, and it will continue on through the next cycle of expected interest rate hikes." Prudential analyst Vikas Dwivedi says Con Edison's safe but generous yield appeals to income-focused investors who were originally drawn into utility stocks after President Bush's 50% dividend tax cut in 2003.