Invest In Utilities Since The Fed Remains Dovish
Summary Utility stocks are often discarded as boring but provide stable income through dividends. The Fed decided not to raise interest rates in their September meeting but indicate by the end of the year would be appropriate. Utilities should be held in a diversified portfolio as an alternative to long duration bonds. This was supposed to be the month. The first time since 2006 the Fed raised interest rates. It turned out to be another case of the Fed getting cold feet. After all, the rest of the world’s central banks continue with their easy monetary policy. The case has been made that 25 basis points won’t make a difference so why not raise rates? On the other side of the argument, if 25 basis points doesn’t make a difference, why risk blowing up the stock market over it? The Fed’s statement was dovish indicating that we could continue to see interest rates held near zero into next year. The market believes the Fed will not move this year as indicated by Bloomberg’s world interest rate probability monitor. Bloomberg currently shows the market indicating an 18% probability of a rate increase in October and 43% of an increase in December. These figures were at 44% and 64% respectively prior to the Fed meeting earlier this month. Yellen gave a speech last week stating she still believes it would be appropriate to raise rates by the end of the year. If the Fed is in fact data dependent, what will change in the next two and a half months in the data that will significantly change the Fed’s view that it’s time for liftoff? The answer is nothing. So investors continue on with no clarity from the Fed. The Fed presidents meet and decide not to raise rates and then the next week give speeches indicating that a rate increase would be appropriate. It makes no sense. Why utilities make sense now This confusion over the Fed lead me to the utility sector. The dividend yield of the S&P 500 Utilities index is currently 3.66% versus the 30 year treasury yield at 2.96%. That’s an extra 70 basis points in yield for holding utilities for just one year as compared to holding the treasury for 30 years. This is not a new trade as utility yields have been relatively attractive for some time. Utilities provide stable income for portfolios as they tend to trade more like bonds but I see less downside risk for utility stocks if the Fed were to raise rates. My thought is as rates increase, the cost of capital used for stock valuation will also increase which will lower stock prices. The safety of utilities will be a safe bet for stock investors as volatility increases around the rate increase. Stock investors will seek the stability of utilities which would increase the value of the sector and it should outperform. On the other side, if the Fed continues to keep rates low into next year, utilities provide a relatively decent yield as compared to bonds and much better than leaving money in the bank to lose value in real terms after factoring in inflation. Even if the Fed does raise rates, they have indicated the pace will be slow. Utility Index ETF’s provide better diversification An easy way to add utility exposure is to buy a utility index ETF such as (NYSEARCA: VPU ), (NYSEARCA: IDU ), or (NYSEARCA: XLU ). These funds provide exposure to the respective index the ETF tracks which pay around a 3.6% dividend yield (each fund yield is slightly different depending on holdings). Using an ETF is also an easy way to diversify your utility holdings so you don’t have concentrated exposure to one utility in case there are problems. There are many regulatory factors to consider with individual utility companies and the states they operate in. The capital structure of these companies and their subsidiaries can be pretty complicated as well. If you don’t have the time and patience to take a deep dive into an individual stock, then an ETF would be the way to go. PEG looks relatively attractive Looking at the relative value metrics of the utility sector and the stock that stands out to me is Public Service Enterprise Group (NYSE: PEG ). While PEG does not pay the highest dividend yield, the P/E and EV/EBITDA ratios are below the sector average. An important consideration for a utility is the dividend coverage ratio. PEG has a coverage ratio of 1.75x which is above the average of 1.42x. This is a direct result of the lower debt profile of PEG. With less income going towards interest payments and debt, this leaves more cash flow available for equity. The utility industry is characterized by high debt loads due to the considerable size of the capital expenditures required to maintain their plant assets. PEG has one of the most attractive debt profiles with just 26% total debt to assets and 69% debt to equity. Name Mkt Cap – USD EV/TTM EBITDA EV/EBITDA FY1 P/E Dividend Yield Average 26.02B 8.78 9.01 15.59 3.98% DUKE ENERGY CORP (NYSE: DUK ) 48.67 8.62 9.54 17.35 4.54% NEXTERA ENERGY INC (NYSE: NEE ) 45.41 9.27 10.13 17.96 3.08% DOMINION RESOURCES INC (NYSE: D ) 41.64 13.85 12.4 20.14 3.63% SOUTHERN CO/THE (NYSE: SO ) 40.09 10.97 9.88 16.22 4.84% AMERICAN ELECTRIC POWER (NYSE: AEP ) 27.47 8.67 8.68 15.37 3.79% P G & E CORP (NYSE: PCG ) 25.89 8.74 8.25 13.46 3.44% EXELON CORP (NYSE: EXC ) 25.42 5.81 7.37 10.93 4.20% PUBLIC SERVICE ENTERPRI 20.69 6.33 7.23 14.19 3.77% Source: Data from Bloomberg Conclusion While the Fed keeps investors confused about the timing of the first interest rate increase, it makes sense to remain defensive with portfolios. Lower inflation due to cheap oil means the Fed will be slow with the interest rate hike. Dividend paying utilities seem to be a better play versus other stock sectors as the stable income provides some downside protection while being a more attractive option to long duration bonds.