The utilities sector is a relatively small part of the domestic blue-chip stock scene. In any given year, utilities stocks account for approximately 3% of the market capitalization of the S&P 500 Index, far behind other sectors like energy, industrials, consumer defensive and cyclicals, health care, financials and technology. This remained roughly constant during the 10 years leading up to 2015, while other sectors rose and fell dramatically.

The stability of utilities is a little surprising, given the natural advantages utilities stocks have in a low-rate environment. Yield and dividend-hungry investors tend to favor utilities, which are often protected from competition by local government monopoly privileges. This also lets utility companies assume above-average debt loads and, in the process, realize greater interest rate sensitivity.

With the potential of rising rates in 2016 and 2017, this sector's debt levels should receive further scrutiny from rating agencies and investors. Here's a short review of debt in the utilities sector:

The Role of Debt in the Utilities Sector

Since utility companies often have huge capital expenditures, meaning it takes a lot of infrastructure and upkeep to build and maintain a utilities delivery nexus, utilities providers make extensive use of debt financing. For the country's largest utility companies, such as Duke Energy Corp. (NYSE: DUK), this usually means large bond issues to raise capital.

Utility bonds also tend to be traded at wide yields. Generally speaking, blue-chip utility providers are able to maintain lower debt levels than their smaller counterparts, but higher-than-average debt levels compared to most other industries. Subsequently, S&P 500-listed utilities companies often have credit ratings that are better than industry averages, but worse than market averages.

In accounting terms, utilities companies tend to have large accounts receivable and accounts payable balances. The first 15 years of the 21st century witnessed a revolution in accounts receivable recovery in the utilities sector. Companies became better at collecting money owed to them, meaning they could afford to take on more of their own debt as cash flow improved.

Utilities Debt Levels From 2006 to 2015

As in many sectors, total debt levels for utility companies rose between 2006 and 2008, before the Great Recession hit and austerity roared back. The average debt-to-asset ratio of S&P 500-listed utility stocks was 36.99% in 2006 and 37.25% in 2008, after which borrowing momentum slowed.

By 2010, the average debt-to-asset ratio hit 36.26%. It sunk further in 2011 to 35.54%, and remained relatively flat in 2012, at 35.82%. A drop from 37.25% in 2008 to 35.54% in 2011 may not seem significant, but it represents a near 7% downward shift in the debt accumulation trend line for utilities sector from 2007. However, debt levels looked to be picking back up between 2014 and 2015.

Leading the deleveraging charge was CenterPoint Energy Inc. (NYSE: CNP), which reduced its total debt-to-assets ratio from 52% in 2008 to approximately 40% in 2015. The reduction strategy appeared to pay off in early 2016, when rating agency Fitch affirmed the utility's long-term issuer default rating (IRD) at "BBB" and praised the company's commitment to debt reduction.

Going in the opposite direction was NRG Energy Inc. (NYSE: NRG), which grew its debt-to-asset ratio from a low of 32.9% in 2008 to 59.2% in 2015. One of the United States' largest energy providers, NRG relied heavily on borrowing to acquire several other operations between 2013 and 2015. Moody's fired a warning shot at subsidiary NRG Yield in September 2015, warning of a possible credit downgrade.

What It All Means

The end of the Federal Reserve's zero interest rate policy (ZIRP) is widely viewed as troubling for U.S. utility companies. Dividend-heavy utility stocks became increasingly attractive as yields on traditional income instruments collapsed, but a rising rate environment would jeopardize that momentum. To make matters worse, debt-heavy utilities companies would see significant increases in their own financing costs.

In light of these factors, it's probably a bad sign that sector-wide debt ratios are climbing. Investors should look for proactive utility providers to pay off debts and strengthen balance sheets moving forward.

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