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How Utilities Respond to Interest Rate Changes

Written By Briton Ryle

Posted February 27, 2015

In her testimony at this week’s Senate and House hearings, U.S. Federal Reserve Chair Yellen reiterated the FOMC’s reliance on economic data in deciding when to begin the long awaited interest rate normalization process back to normal historical averages. With the Federal Funds Rate at near zero percent for over six years, many feel the long trek back to the 5 to 6% historical average is long overdue.

Although Yellen gave no definitive indication as to when the first interest rate hike will come, she did mention that it could come at any meeting of the central bank’s Federal Open Market Committee. When it finally does come, we can expect a little bit of shake-up on all markets from equities, to bonds, to currencies.

While the U.S. dollar is expected to strengthen on any interest rate raise, bond prices are destined to move the other way, falling in value and their interest yields rise. Equities, for their part, while probably falling a little on the initial shock of the first rate change in over six years and the first interest rate raise in over eight years, will undoubtedly resume their upward trajectory, since the Fed’s move will demonstrate the central bank’s confidence that the economy is strong enough to carry itself forward without so much monetary assistance.

But what about that other large group of investments that investors have been speculating on so intently: utilities? Utilities have benefitted greatly from the last six years of near-zero interest rates to finance their operations and new projects at unheard-of low borrowing costs, and investors have benefitted from their high dividends which are higher than the average corporate payouts.

Will the upcoming cycle of rising interest rates bring an end to the utilities play? There are three strong indications that the answer is, “No.” If anything, rising rates should lift utilities even higher.

Before looking at how utilities generally respond to changes in interest rates, let’s first look at why interest rates are so important to utilities in the first place.

Utilities’ Dependence on Debt

After banks and mortgage lenders, whose income depends on the current level of interest rates, utility companies are perhaps the next group of companies most affected by interest rates, given their exceptionally high debt loads.

Building power plants to generate electricity, gas plants to heat homes and businesses, and the thousands of miles of cable and pipeline infrastructure to deliver all that electricity and gas are extremely expensive activities, which give utility companies some of the highest debt-to-market cap ratios around. Just note the debt-to-market cap ratios of the nation’s six largest Diversified Utilities companies as compared to a cross-section of other large corporations:

• Duke Energy Corporation (NYSE: DUK), 76.58%

• Exelon Corporation (NYSE: EXC), 76.27%

• NiSource Inc. (NYSE: NI), 74.35%

• Eversource Energy (NYSE: ES), 57.58%

• Sempra Energy (NYSE: SRE), 52.19%

• Public Service Enterprise Group Inc. (NYSE: PEG), 41.95%

• Wal-Mart Stores Inc. (NYSE: WMT), 18.61%

• McDonald’s Corp. (NYSE: MCD), 15.62%

• The Boeing Company (NYSE: BA), 8.49%

• 3M Company (NYSE: MMM), 6.41%

• Exxon Mobil Corporation (NYSE: XOM), 5.86%.

Looking at the list above, I don’t need to tell you where the utilities companies end and the other companies begin.

Stephanie G. Bigwood, CFP, ChFC, CSA, Assistant Vice President, Lombard Securities, Incorporated, Baltimore, MD, elaborates on the effects of these high debt burdens on the utilities, their customers, and their investors:

“Some utility companies have been able to successfully overcome more difficult times associated with bringing large construction projects into their ratepayers’ rate base, thus enabling the companies to pass on to these ratepayers the costs of constructing the projects.” Bigwood then contrasts, “Other companies have been forced to pass some or all of these costs on to their stockholders, meaning that these companies’ earnings have been hurt severely. The harm to earnings, of course, also adversely affects the utilities’ bondholders because these companies’ financial ratios—that is, interest-coverage ratios and debt to equity ratios—are reduced and credit rating agencies are likely to reduce credit ratings as a result.”

Bigwood underscores investors’ main concern over how rising interest rates could harm utility companies, as the increased cost of borrowing money will filter through the utilities’ business structure. While some utilities can successfully overcome that obstacle by passing the higher borrowing costs onto their customers through higher energy bills, other utilities may be operating in regions where their customers simply cannot afford to pay more.

In these regions, utility companies are forced to passed their higher borrowing costs onto their investors, meaning their bond and stock holders. This ultimately results in lower net profit for the utilities, hurting their credit scores which makes the next round of fund-raising through bond and stock sales even more costly to the utilities, resulting in investors dumping utility shares which then plummet in price.

“These factors all contributed to the market’s perception of greater risk in the utility industry,” Bigwood continues. “Still, other very positive trends have occurred, such as high interest costs having been reduced through refinancing at lower interest costs. Now we observe that many utility companies are becoming cash cows.”

During these past several years of ultra-low interest rates, utility companies have greatly benefitted from access to cheap money, which has enabled them to improve their infrastructure and optimize their operational efficiency, helping to improve their returns – all thanks to lower interest expenses which have resulted in huge cash flows that have made their way into investors’ pockets through some of the highest dividend rates around.

While investors now worry that all of these benefits to the utilities, their customers and their investors will disappear when interest rates begin rising, we have three compelling reasons to push those worries out of our minds.

Why Utilities Won’t Suffer From Rising Rates

The first reason why we can expected utilities not to suffer as much as investors believe is explained by Bigwood as stemming from the huge cash flows she noted above:

“The excess cash flows generated by some of them have enabled them to buy companies in nonregulated industries, thus reducing their vulnerability to political influences and allowing them to participate in more growth-oriented businesses. In short, in many cases utility companies are turning the corner on their past problems, and their bonds are trading more and more like industrial bonds in those selected cases.”

The past few years of ultra-low interest rates have increased the utilities’ profits, giving them greater purchasing power which they have put to good use in buying other businesses that are not so capital intensive. In so doing, many utilities have diversified into activities that are not as tied to interest rates as their main utility operations are, and will thus be less adversely affected when interest rates begin to rise.

A second reason why utilities won’t suffer from rising rates in the future is their past track record, as graphed below.

Utilities Interest Rate Hike 1


During the interest rate tightening cycle of 2000 to 2003, as shown above, the utility sector as represented by the SPDR Utility Sector ETF (NYSE: XLU) [beige] fell too, as shown below. Then, as interest rates rose from 2004 to 2007, XLU rose with them.

This close correlation between utilities and interest rates was maintained yet again as interest rates fell in 2008-09, as utilities followed rates lower yet again.

Since then, from 2009 until today, interest rates have remained flat, while utilities have been rising due to investors’ hunt for yield, which the utilities offer most generously due to their enormous cash flows enabled by ultra-low financing rates as explained above.

Utilities Interest Rate Hike


But why is there such a strong correlation between utilities and interest rates? Isn’t this counter-intuitive? Shouldn’t rising rates hurt utilities since they are always so heavily indebted? Why did utilities rise in value when interest rates rose in the past?

Simply put, interest rates rise when the Fed is confident the economy is strong, jobs are plentiful, consumerism is vibrant, and inflation is rising. This means consumers can afford higher energy prices, enabling most utilities to pass the higher cost of borrowing at higher interest rates onto their customers through higher energy bills.

The end result is that the utilities can still generate increased profit in a rising interest rate environment, since the economy is thriving, leading to increased energy consumption, which increases the utilities’ profits.

The third reason why utilities are expected to continue to be great investments even in a rising interest rate environment is because they will have to pay their bond holders more interest and their stock holders more dividends just to keep their investments rolling in. As the cost of borrowing increases, investors will receive more from their investments in utilities, the cost of which is passed onto their consumers.

Investors Need Not Fear Utilities

So while the general attitude toward utilities is that they are ticking time bombs that will explode when interest rates begin to rise, thereby bringing an end to this more than six year bull run in utilities, the truth is that rising rates will benefit utility stocks as they have in the past, and will also increase the dividend yield offered to investors.

While the overall market will always outperform the utilities in as much as capital gains are concerned, the utilities will forever remain among the best dividend investments on the market – even in an era of rising interest rates.

Joseph Cafariello