What is the Utilities Sector
The utilities sector is a category of stocks for utilities such as gas and power. The sector contains companies such as electric, gas and water firms, and integrated providers. Because utilities require significant infrastructure, these firms often carry large amounts of debt; with a high debt load, utilities companies become sensitive to changes in the interest rate.
BREAKING DOWN Utilities Sector
As high-yielding equity investments, utility stocks are subject to interest rate risk. As a result, higher interest rates mean increased cost of capital for utility companies. For example, in 2015, the U.S. Environmental Protection Agency (EPA) proposed a plan for lowering carbon pollution from domestic power plants by 30% from 2005 levels by 2030. Electric utilities relying mostly on coal and without appropriate retrofit for scaling down their carbon footprint would be the most affected. DTE Energy management estimated needing $15 billion to upgrade energy infrastructure to match the EPA’s required environmental standards. The company would need to invest approximately $7 billion to $8 billion to meet the energy policy’s standards.
Debt Levels of the Utilities Sector
Because utilities are capital-intensive, they need a continuous inflow of funds for carrying on their infrastructure upgrades and growth. The processes are necessary for maintaining the continuous supply of electricity, fresh water, gas and other basic amenities. Utilities use some funds generated from operations, but most funds are used for paying dividends. External sources are typically used for financing capital requirements.
As a result of relying on other financing methods and depending on market conditions, utilities companies may end up paying higher interest rates on their debt. Borrowing at higher rates contributes to the companies’ increasing debt levels, resulting in steep debt-to-equity ratios impacting the companies’ credit ratings. When credit ratings go down, utilities companies have difficulty borrowing funds at reasonable rates. As a result, the cost of operations increases.
Consumer Impact on Utilities Sector
Because many states let consumers move from one utility operator to another, consumers typically choose the least expensive operator in the area. Higher-cost producers are eventually eliminated from the market unless they can cut their costs.
Long-term power purchase agreements between companies and consumers also impact profits. When utility generation costs increase, companies still have to follow contract agreements and sell utilities at preset rates, which decreases their profits.
Because utility stocks pay reliable dividends like bonds do, the stocks compete with bonds as consumer investment options. After the financial crisis of 2008, and the resulting almost-nonexistent interest rates lasting a long time, utility companies benefited from conservative investors buying the companies’ stocks rather than bonds. In contrast, increasing interest rates make buying bonds more attractive than buying utility sector stocks, further affecting utilities companies’ funding. The Utilities Select Sector SPDR Fund (XLU) pays a dividend yield of 3.5% as of January 2018, well above the yield of the S&P 500 and the U.S. 10-year Treasury note.
Growth in the housing sector may trigger growth in the utilities sector as demand for electric power and water increases.
Upside of Utilities Investments
In addition to packing hefty dividends, stocks in the utilities sector tend to be reliable and slow but steady growers if held for the long term. Thus, investment managers often include them in a defensive or income-oriented portion of a portfolio. Conservative investors also turn to them in economic downturns when other stocks can become more volatile.
Downsides of Utilities Investments
Investors in the utilities sector should be mindful of a variety of risks, despite government regulations that offer some stabilization. Economic growth, changing environmental regulation and increasing interest rates can all negatively impact companies and erode or lead to cancelation of dividend yields. In addition, natural disasters and changing commodity prices may hit their bottom lines.