What Is the Utilities Sector?

The utilities sector refers to a category companies that provide basic amenities, such as water, sewage services, electricity, dams, and natural gas. Although utilities earn profits, they are part of the public service landscape, and are therefore heavily regulated. Investors typically treat utilities as long-term holdings, and use them to inject steady income income in their portfolios.

Utilities Sector Explained

Utilities typically offer investors stable and consistent dividends, coupled with less price volatility relative to the overall equity markets. Because of these facts, utilities tend to perform well during recessionary climates. Contrarily, utility stocks tend to fall out of favor with the market, during times of economic growth.

The many types of utilities available include large companies that offer multiple services such as electricity and natural gas. Other utility interest might specialize in just one type of service, such as water. Some utilities rely on clean and renewable energy sources like wind turbines and solar panels, to produce electricity. Investors may also purchase regional utilities or invest in exchange-traded funds (ETFs) containing baskets of utility stocks located throughout the U.S.

Paradigm Shift

While electric utility companies used to be regionally monopolistic, broadly speaking, the industry is breaking down into the following four supplier segments:

  • Generators: These operators create electrical power. 
  • Energy Network Operators: Grid operators, regional network operators and distribution network operators sell access to their networks to retail service providers.
  • Energy Traders and Marketers: By buying and selling energy futures and other derivatives and creating complex "structured products," these companies usefully help utilities and power-hungry businesses secure a dependable supply of electricity at a stable, predictable price. 
  • Energy Service Providers and Retailers: In most U.S. states, consumers can now choose their own retail service providers.

Key Takeaways

  • The utility sector is a category of company stocks that provide basic services including electricity, natural gas, and water.
  • Utilities earn a profit but are a public service and, as a result, have substantial regulation.
  • Typically, investors buy utilities as long-term holdings for their dividend income and stability
  • The utility sector tends to do well as a defensive play against macroeconomic downturns.
  • As the economy improves and interest rates rise, investors can find higher-yielding alternatives to utilities.

Debt Levels of the Utilities Sector

Utilities require a significant amount of expensive infrastructure and consequently carry large amounts of debt on their balance sheets. These debt loads make utilities hypersensitive to changes in the market interest rate. And because utilities are capital-intensive, they require a continuous inflow of funds to finance infrastructure upgrades and new asset purchases. The significant debt load also results in high utility debt-to-equity (D/E) ratios, which can impact companies’ credit ratings, making it difficult to borrow funds, which ultimately increases their costs of operations.

Consumer Impact on Utilities Sector

Because many states let consumers move from one utility operator to another, consumers typically choose the least expensive local operator. Higher-cost producers are eventually eliminated from the market, unless they can cut their costs in time.

Long-term power purchase agreements between companies and consumers also impact profits. When utility generation costs increase, companies must continue to honor the contract agreements and sell utilities at the current agreed-upon rate, which decreases their profits.

How Investors Trade Utilities

Because utility stocks pay reliable dividends, investors often favor them over lower-dividend paying equities. After the financial crisis of 2008, the Federal Reserve cut interest rates, in an effort to stimulate the economy. As a result, investors flocked to utilities, as safer investments. Simply put: utility companies are a viable defensive choice for investors during macroeconomic downturns.

However, as the economy improves and interest rates rise, investors can find higher-yielding alternatives than utilities. As rates rise, so do the yields of U.S. Treasury bills. For example, if a utility pays a dividend yield of 3%, but increasing interest rates spike bond yields to 4%, the utility company would have to increase its dividend payout in order to match the rising yields of Treasuries. Therefore, utilities do well when interest rates decrease, because their dividends are greater than Treasury yields. However, as the economy improves, utilities tend to sell off as interest rates rise back to normal levels and their dividends become once again lower than Treasuries.

Pros and Cons of the Utilities Sector

Utilities are stable investments that provide a regular dividend to shareholders, making them a popular long-term buy-and-hold option. Dividends yields are usually higher than those paid by other stocks. During times of economic downturns or with low market interest rates, utilities provide a stable, haven investment. Investors may invest in utility company shares, industry sector ETFs, and in utility bonds or other debt securities.

Due to the utility sector's intense regulatory oversight, it's difficult for it raise rates to increase revenue. Utilities requires expensive infrastructure that needs routine updating and maintenance. To meet these infrastructure needs, utility companies often float debt products that, in turn, increase their debt loads. This debt also makes these services particularly sensitive to interest rate risk. Should rates rise, the company must offer higher yields to attract bond investors, driving up their costs. 

Pros

  • The utility sector offers stable, long-term investments with a regular and attractive dividend.

  • Utilities act as a haven investment during times of economic downturns.

  • Utilities offer many options for investment including bonds, ETFs, and individual company stocks

Cons

  • Intense regulatory oversight causes difficulty in raising customer utility prices to increase revenue.

  • Expensive utility infrastructure requires continual upgrades and maintance.

  • During times of high market interest rates, utilities become less attractive and must increase their bond yields.

Real World Example of Utilities

Investors can buy into individual utility stocks or bonds, or they can invest in ETFs that comprise baskets of many utilities. For example, the Utilities Select Sector SPDR Fund (XLU) is one of the largest utility sector funds, with a whopping $9 billion in assets under management. The ETF also is one of the most actively traded utility ETFs, with more than 10 million shares traded daily. The fund typically pays a dividend yield of around 3% with a low expense ratio of 0.13%.

In comparison, the XLU's dividend yield beats out the yield for the S&P 500 equity ETF—SPDR S&P 500 Trust ETF (SPY)—that pays around 1.86%.

Furthermore, if the benchmark 10-year Treasury yield trades below 3%, investors might consider buying the utility sector through the XLU or individual stocks. It's important to check with your broker for current market pricing since Treasury yields, and dividend yields for both utilities and equities change with market conditions.