The cost of hedging against losses in utility shares has risen to a five-year high after rising bond yields made dividends less appealing and short sellers boosted bearish bets.
A gauge of options prices known as implied volatility has risen 8.8 percent to 14.19 in the past month for the Utilities Select Sector SPDR Fund, an exchange-traded security tracking power companies, according to data on three-month contracts compiled by Bloomberg. Implied volatility for the utilities ETF was 1.73 points above the Standard & Poor’s 500 Index ETF on Dec. 26, the most since October 2008.
Utilities, which pay the second-highest dividends in the S&P 500, have declined amid speculation that investors searching for yield may turn to bonds after 10-year Treasury rates reached a two-year high. The Federal Reserve last month took the first step to reining in asset purchases that have helped to reduce borrowing costs. The ETF tracking companies such as Duke Energy Corp. has fallen 9.8 percent from a five-year high reached in April.
“Sentiment toward utilities is negative,” Tim Hoyle, director of research at Radnor, Pennsylvania-based Haverford Investments, said in a phone interview yesterday. His firm oversees about $6 billion. “We’re in a rising rate environment and utilities, which are often seen as an alternative to fixed income, become relatively unattractive.”
Investors have increased bets against utilities, sending the number of shares sold short to 14.9 million, a fourfold increase in two months, according to data compiled by Bloomberg and Markit, a London-based research firm. Almost 13 percent of the outstanding stock has been borrowed to wager on declines, the most since September 2009.
Utilities are sensitive to interest rates because the group competes with bonds for investors seeking stable returns, according to Scott Armiger, chief investment officer at Christiana Trust in Wilmington, Delaware. The industry’s higher levels of debt means earnings are more tied to fluctuations in borrowing costs, he said.
The group paid 4.09 percent of their share price in dividends during the past year, double the payout for the S&P 500, according to data compiled by Bloomberg. That’s also more than all of the 10 main U.S. industries except for telephone companies, which on average offer a yield of 4.70 percent. Debt at utilities companies amounted to 35 percent of total assets, the highest among 10 S&P 500 groups.
The Fed cited “improvement in the outlook for labor conditions” when it said Dec. 18 that it would reduce asset purchases by $10 billion this month. The central bank will probably trim stimulus by $10 billion in each of its next seven meetings before ending the program this year, according to the median estimate of 41 economists surveyed by Bloomberg News on Dec. 19.
The yield on the benchmark 10-year note exceeded 3 percent this week, narrowing the premium that utility stocks offer in dividends to 1.1 percentage points, close to the smallest gap since July 2011, data compiled by Bloomberg show.
Implied volatility on the utilities fund rose 2.9 percent yesterday to a two-month high, according to data compiled by Bloomberg on three-month options with an exercise price near the ETF. The measure for the SPDR S&P 500 ETF Trust added 2.9 percent to 12.85, hovering near the lowest level since 2007.
Utility shares are attractive because they will hold up better than other stocks should the overall market decline, Armiger said. The S&P 500 group trades at 15.5 times reported earnings, the cheapest valuation relative to the S&P 500 in more than two years, data compiled by Bloomberg show.
“All you need is one market correction and that can change in a heartbeat,” Armiger said in a phone interview yesterday. His firm has $6 billion under administration and owns shares of the utility fund. “If the market were to trade off, you could see a run back toward utilities for its defensive nature.”
The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 options prices known as the VIX, fell 3.3 percent to 13.76 at 4:15 p.m. in New York, snapping a four-day rally. Its counterpart in Europe, the VStoxx Index, slipped 4.9 percent to 18 after jumping 9.7 percent yesterday.
Since Dec. 2, the two contracts with the largest increase in ownership were bearish, according to data compiled by Bloomberg. March $37 puts, with an exercise price 1 percent below yesterday’s close, had the biggest increase in open interest. Ownership increased by 15,800 contracts from 892 a month ago.
Ownership of puts expiring in February with the same strike price grew by about 13,000 contracts for the second-biggest increase.
“With tapering having begun there’s an expectation that yields at the long end of the U.S. Treasury curve could rise further,” Jim Strugger, a derivatives strategist at MKM Partners LLC, said in an interview on Dec. 24. “Yield-sensitive sectors are embedding increased risk of higher rates.”