Higher interest rates create a number of risks and opportunities for investors in the utility sector.

Utilities have long been a staple for low risk income investors, such as those that live off dividends during retirement.

That’s because most utilities have long track records of highly secure and slowly growing dividends, thanks to their stable cash flows.

In fact, some utilities are even dividend aristocrats and dividend kings, meaning they have raised their dividends every year for 25 and 50 consecutive years, respectively.

In the past decade, however, record low interest rates have acted as a real growth tailwind, helping these stable electric, water, and gas companies borrow at ultralow interest rates.

In addition, yield-starved investors have turned to utilities such as Consolidated Edison (ED), Southern Company (SO), and Duke Energy (DUK) as high-quality bond alternatives.

With interest rates now rising and the pace of increases potentially set to accelerate in the coming years, many investors are worried about how utilities will do going forward.

Let’s take a look at how this industry is affected by higher interest rates, and why higher rates could pose several growth challenges.

Most importantly, find out how your own diversified dividend portfolio should be positioned in this new era of higher borrowing costs and rising yields.

Why Higher Interest Rates Matter to Utility Investors

Investor-owned utilities are unique in that they are essentially government approved monopolies.

In exchange for a high degree of government regulations regarding pricing, they are allowed a fixed rate of return on equity for the large capital investments they must make in order to construct and maintain their electrical, gas, or water infrastructure.

However, because they have this monopoly power, they also have a guaranteed and largely recession-proof source of very steady cash flow.

Dependable cash flow grants utility companies the ability to borrow large amounts of debt at relatively low interest rates (compared to other companies that have similar leverage ratios).

However, the flip side of this regulated monopoly business model is that the growth rate for utilities is generally pretty low. In fact, the majority of growth often comes from acquiring other utilities.

Much of the money for that comes from the equity markets, specifically in the form of issuing new shares in order to consolidate and grow into new markets.

For example, electric utility Wisconsin Energy Corporation (WEC) has used this equity capital approach to acquire numerous other utilities outside its home state of Wisconsin, as well as diversify into the natural gas business.

Similarly, Dominion Resources (D), one of the fastest growing utilities in America, has used equity issuances to fund numerous deals, including its $4.4 billion purchase of natural gas distributor Questar, as well as its $3.8 billion investment into the Cove Point liquefied natural gas or LNG export terminal.

And as you can see, between 1982 and 2016, when 10-year Treasury yields declined from 14% to just 1.36%, utilities have benefited from decreasing interest rates.

Lower interest rates for utilities not only means declining costs of borrowing, including refinancing previous debt at lower rates, but also a boost to their equity prices.

Interest Rates Utilities

Source: Berkeley Labs

Utilities have benefited from lower interest rates because of the bond-like nature of their stocks.

More specifically, the lower interest rates are, the lower the discount rate investors apply to a utility’s future cash flow, resulting in a higher valuation the stock market is likely to give the stock price.

Think of it like this. Back in 1982 when you could have purchased risk-free Treasuries yielding 14%, the risk premium that investors were demanding from all stocks, even low-risk utilities, was much higher.

That’s because most utilities grow their dividends slowly, which means that there was little reason to pay a substantial premium for a utility stock when Treasuries were offering such high yields.

However, over the past three decades, as yields on risk-free investments have plunged, utility stocks suddenly offered higher and growing yields, making them far more appealing.

Now that interest rates are likely to rise by as much as 2.25% in the coming three or four years (according to the Federal Reserve’s latest rate outlook), investors could once more be able to get higher yields on Treasury bonds – potentially as much as 4%, 5%, or even 6% on 30 year T-bills.

The risk-free interest rate may end up even higher if Finance Secretary Steve Mnuchin gets his way and the U.S. starts issuing longer duration bonds, 50- or even 100-year Treasuries.

In other words, a key catalyst that has been driving investor capital into utilities (as well as other high-yield sectors such as Real Estate Investment Trusts and Master Limited Partnerships could be reversing.

As a result, share prices of most utilities could underperform the market or even fall, resulting in higher yields.

While that’s great for investors looking to put new money to work, it also means higher risks for those with a shorter time horizon

For example, some retirees’ portfolios aren’t large enough to purely live off dividend income, so they must periodically sell shares to pay for expenses.

It also means that the utility industry in general will likely face higher costs of capital, due to higher interest rates on new debt as well as lower valuations on share prices.

That could make it harder to find profitable growth opportunities with which to grow cash flow and thus their dividends.

Additionally, since the long-term total return for dividend growth stocks generally follows the formula dividend yield plus dividend growth, this could mean lower total returns for the sector going forward.

Future total returns could also be lower when you consider that the utilities sector trades at a forward P/E multiple of 17.9, which is 14% and 25% higher than its 5- and 10-year average multiples, respectively (according to FactSet data).

The Trump administration’s tax reform also poses a threat to one of the financial benefits of the utility industry. Specifically, the risk that the interest deduction will be eliminated in order to help pay for corporate tax rates to be lowered from 35% to 20%.

Utilities, because of their high debt loads, rely heavily on the ability to deduct their interest expenses, which helps lower their tax obligations and boost earnings.

In fact, according to an analysis by Bloomberg and Morgan Stanley, some utilities could face an earnings hit of as much as 8.5% if this provision of tax reform ends up becoming law.

Interest Rates Utilities

Source: Morgan Stanley, Bloomberg

Also keep in mind that over the past few years a new kind of utility has become increasingly popular, specifically limited partnerships such as Brookfield Infrastructure Partners (BIP) and YieldCos such as 8Point3 Energy Partners (CAFD), NextEra Energy Partners (NEP), and Brookfield Renewable Partners (BEP).

These pass-through utilities are similar to MLPs in that the majority of cash flow is paid out as distributions, or a tax-deferred form of dividend.

However, while that means even higher yields than most traditional C-corp utilities, it also means that almost all of the growth capital for such utilities (which generally operate as solar, wind, and hydroelectric utilities) must come from external debt and equity markets.

Up until now, low interest rates have been a boon to such non-traditional

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