Typically, utilities stocks are inversely correlated to changes in U.S. interest rates. However, the Federal Reserve raised interest rates for the first time this year in March, inflicting very little damage upon the Utilities Select Sector SPDR (XLU) and rival utilities exchange-traded funds (ETFs).

In fact, XLU, the largest utilities ETF by assets, is up 6.4 percent year to date. That is better than the 5.9 percent returned by the S&P 500. Among the sector SPDR ETFs, XLU currently ranks fourth on a year-to-date basis. One of the primary reasons investors embrace slow-growth utilities stocks and ETFs like XLU is yield. For its part, XLU's dividend yield is nearly 3.3 percent, a metric that can be instructive at a time when U.S. interest rates are rising. (See also: XLU: Utilities Select SPDR ETF.)

"We've long told investors that a wide spread between utilities' dividend yields and interest rates would dampen the market's reaction to rising rates," said Morningstar in a recent note. "That has played out. Even as 10-year U.S. Treasury rates have climbed to 2.6 percent in early March, utilities' average dividend yields fell to 3.5 percent now." (See also: To What Extent Are Utility Stocks Affected by Changes in Interest Rates?)

Utilities stocks are often thought of as bond proxies, but over the past year, XLU is up 6.5 percent, while the iShares 20+ Year Treasury Bond ETF (TLT) is off 5.6 percent. TLT has an effective duration of 17.3 years, underscoring the ETF's sensitivity to interest rate changes. "Utilities have cast aside conventional stock investing wisdom," said Morningstar. "Defensive income-oriented stocks like utilities should be suffering in this market. The economy shows signs of improving, interest rates are rising, the U.S. Fed remains hawkish, and politicians appear set to implement expansionary fiscal and tax policies."

Still, there are issues confounding the utilities sector, including slack relative performance against the broader market and high valuations. The utilities sector currently trades at valuations that are above the sector's 10-year average and only slightly below its 10-year high, according to State Street data. (See also: Utilities Aren't Just for Yield.)

"First, relative performance likely will continue to suffer. Two-thirds of the U.S. utilities we cover trade at more than a 10 percent premium to their fair value estimates," said Morningstar. "This is above Morningstar's overall market valuation after adjusting for the low uncertainty ratings we assign to most utilities. Second, investors should be able to earn solid cash returns from utilities based on the combination of current dividend yields and our projected dividend growth. Among the U.S. utilities we cover, we forecast 5.5 percent median annual dividend growth during the next four years."

Year to date, investors have pulled $248.5 million from XLU. (See also: Best ETFs for a Rate Hike.)

 

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