Utilities ETFs Could be Vulnerable to Dividend Cuts

It is an easy economic scenario to understand. Utilities, arguably more than any other sector, are adversely affected by rising interest rates. A spike in rates means higher borrowing costs for a capital intensive business and, on a historical basis, high interest rate environments have prompted some utilities to pare dividends.

Concerns over rising interest rates explain in large part why the Utilities Select Sector SPDR (NYSE:XLU) and other formerly darling utilities ETFs explain why investors have punished these products. In the past month, XLU has tumbled about eight percent, an exceptionally large, volatile move for the sector SPDR fund with the lowest beta to the S&P 500.

If one analyst is right, more pain could be ahead for some utilities stocks on the dividend front. In a note out Friday, Bernstein analyst Hugh Wynne identified eight utilities that are least likely to sustain their dividends.

In terms of the potential dividend impact from the group Wynne highlighted on XLU, Consolidated Edison (NYSE:ED) and Pepco Holdings (NYSE:POM) were identified as unlikely to sustain their current dividends. Those stocks combine for 4.7 percent of XLU's weight. The analyst said shares of Pepco are overvalued.

Wynne did say there are some companies in the utilities space that can sustain their dividends. His list includes CMS Energy (NYSE:CMS), Edison International (NYSE:EIX), Wisconsin Energy (NYSE:WEC), OGE Energy (NYSE:OGE), El Paso Energy (NYSE:EE) and Integrys (NYSE:TEG). Edison Interesting, Wisconsin Energy, CMS and Integrys combine for about 7.8 percent of XLU's weight.

One unheralded ETF could be affected by potential utilities dividend cuts as well. The PowerShares S&P SmallCap Utilities Portfolio (NASDAQ:PSCU), which is down just 3.2 percent in the past month, holds significant weights to some of the stocks Wynne sees as vulnerable to potential dividend reductions.

Wynne's list of utilities that could lower dividends included Avista (NYSE:AVA), UIL Holdings (NYSE:UIL) and UNS Energy (NYSE:UNS). Those three stocks combine for 19.3 percent of PSCU's weight. PSCU has a trailing 12-month dividend yield of 3.69 percent, which is 16 basis points below XLU. The small-cap offering charges annual fees of 0.29 percent.

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