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.
Likewise, the Bank of Korea's recent announcement that it intends to diversify its currency holdings caused 10-year rates to rise 3 more basis points and sent the IDU down 2.5%. Utility investors might be able to withstand such minor scares while the Fed takes its "measured" approach to raising rates. But what would really frighten them would be a repeat of the 1994-95 period. Back then, the central bank doubled its overnight lending rate, triggering a 33% plunge in the Dow Jones Utility Index. Judith Saryan, portfolio manager for the $632 million ( EVTMX) Eaton Vance Utilities fund, says that slower-than-expected economic growth will prevent the Fed from hiking rates to a level that would crush utility returns. And while she does not expect a repeat of last year's gains -- her fund returned 25.1% last year -- she sees a good year ahead for utilities even in the midst of interest rate uncertainty. "Utility fundamentals in the form of earnings growth are positive, perhaps even better than the overall market," says Saryan. "And several companies like Exelon ( EXE) will be raising their dividends this year -- making them even more attractive to investors." Exelon was the third-largest holding in Saryan's fund as of December. Exelon was also one of the top picks of Shaun Hong, portfolio manager for the $3 billion ( PRUAX) Jennison Utility fund. Hong likes the company, along with fellow nuclear power generator Entergy ( ETR), primarily for their abilities to charge more for the nuclear power they generate, thereby increasing margins as nuclear fuel costs remain steady. Edward Paik, portfolio manager for the $410 million ( CUTLX) Columbia Utilities fund, says a pair of once-troubled California utilities -- PG&E ( PCG) and Edison International ( EIX) -- could withstand interest rate pressures. He says that's due to the massive reversal in sentiment about regulation after the Golden State's energy crisis a few years ago.
"Regulatory tailwinds should help these companies grow dividends even if the group as a whole is more susceptible to interest rate moves," says Paik. A final reason why rising rates won't cause utility funds to collapse, says Morningstar's Kathman, is the diversity of their holdings. Kathman points out utility funds were boosted not only by their exposure to energy related shares last year, but by their holding foreign-based utilities, which tend to rise in value as the dollar weakens. German energy provider E.ON ( EON), for example, is up over 30% over the past year and can be found in a number of utility funds, including Eaton Vance's.