As Rates Rise, A Tepid View On Utilities ETFs

Ten-year Treasury yields dropped nearly three percent on Friday, barely enough to put a dent in a 90-day spike of about 40 percent. As has been well-documented, rising interest rates present problems for income investors.

Obviously, rising interest rates wreak havoc on bond portfolios that are heavily allocated to longer duration fare. Those same rising rates also plague other asset classes with bond-like traits, such as MLPs, REITs, preferred stocks an the utilities, a scenario that makes scores of dividend ETFs vulnerable.

Conservative investors still like utilities stocks and ETFs because the sector's low correlation to the broader market and robust dividend yields.

"The sector pulled back in the next six weeks, due, we think. to uncertainty about the sustainability of low interest rates, but then recovered a portion of its pullback after the Fed announced that it was planning to keep interest rates low," said S&P Capital IQ in a new research note. "However, the sector has since declined further as investors once again appear to be having serious doubts about the Fed's commitment to maintaining low interest rates. Electric utilities are always sensitive to the direction of interest rates, since low interest rates not only decrease the cost of capital for the substantial amount of debt that utilities must sell, but also increase the relative value of utility stocks' dividends."

S&P Capital IQ is bullish on a few utilities stocks, bestowing four-star ratings on Consolidated Edison (NYSE:ED), PPL (NYSE:PPL) and Southern (NYSE:SO). The research is slightly less enthused by NextEra Energy (NYSE:NEE) and Public Service Enterprises (NYSE:PEG), rating both stocks three stars.

Southern, NextEra, PPL and ConEd are all top-10 holdings in the $5.3 billion Utilities Select Sector SPDR (NYSE:XLU), combing for about 23 percent of that ETF's weight. At the end of the second quarter, those stocks combined for 18.2 percent of the Vanguard Utilities ETFs' (NYSE:VPU) weight.

"Both ETFs are in the top quartile of their asset class for their low volatility, with three-year standard deviations of 10.24 for VPU and 10.73 for XLU, as well as for their low cost, with gross expense ratios of 0.14 for VPU and 0.18 for XLU," said S&P Capital IQ.

However, the research firm has Marketweight ratings on both ETFs. Since talk of Federal Reserve tapering of quantitative easing started in earnest three months ago, causing the subsequent rise in Treasury yields, XLU and VPU have lost 3.9 percent and 3.3 percent, respectively.

Those declines have made the utilities sector, previously viewed as richly valued relative to historical standards, only slight cheaper. In early May, XLU had a P/E ratio of 16.77. Today, it is 15.4.

Investors looking to stay in the utilities game without the interest rate sensitivity of U.S.-focused ETFs, can consider international funds such as the WisdomTree Global ex-US Utilities Fund (NYSE:DBU). Over the past month, DBU is down 3.1 percent, but that is far better than the 5.3 percent loss sported by XLU. Additionally, DBU's 30-day SEC yield is 5.04 percent, more than 100 basis points higher than XLU's.

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Disclosure: Author owns none of the securities mentioned here.