For Once High-Flying Utilities, Fed Rate Raise is Bad News

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  • Sector outperformed the S&P for most of this quarter
  • Rising rates would likely drive down utility stock prices

For a few weeks, utilities were stock stars.

They outperformed the S&P 500 Index for much of this quarter as concern that lower Chinese demand for global goods weighed on the stock market. Investors flocked to utilities that offer reliable, regulated returns and steady dividends.

A Federal Reserve decision Thursday on interest rates threatens to end the attraction.

“Interest rate increases are historically negative for utility stocks,” said Kit Konolige, senior utility analyst for Bloomberg Intelligence. "They react a lot like the way the bond market does when interest rates rise, which is negative."

While analysts remain divided over whether the Fed will raise rates, the anticipation is already weighing on markets for everything from equities to energy producers to commodities. Utilities have proven to be among the most vulnerable to rate decisions because of their high capital costs and the time it takes for regulators to set their revenues.

“The single most important risk to the relative performance of the regulated utilities over the next 12 months is the possibility of rising Treasury bond yields,” analysts at Sanford C. Bernstein led by Hugh Wynne wrote in a Sept. 9 note.

Higher interest rates would be a "credit-negative" for the U.S. utility sector and would mean higher borrowing costs for the capital-intensive industry, according to a Moody’s Investors Service research note Wednesday. Producers that sell power at wholesale market rates instead of state-regulated prices are the most vulnerable because there’s no guarantee they can recover higher capital costs, Moody’s said.

Fed Expectations

The utility sector already faces headwinds. It’s now fairly valued against the broader market based on earnings expectations after beating the S&P 500 this quarter, Bernstein analysts said. So utilities are poised to lag behind the broader market.

Economists expect that over the next year the Fed’s tightening will cause 10-year U.S. Treasury yields to rise by 80 basis points, or 0.8 of a percentage point, to damp inflation, Bernstein analysts said. That would be bad for utility stocks. An increase of more than a percentage point is much worse.

The Bernstein analysts looked back 43 years and found that utility stocks trailed the S&P 500 by 1.9 percent when interest rates rose less than a percentage point. When rates rose more than a percentage point, they underperformed by more than 11 percent most of the time.