Utility Stocks Face Risks From Higher Interest Rates

Special Report:Income Investing

Utility stocks have produced strong returns in recent years, thanks to rising share prices and steady dividend growth.

But the prospect of higher interest rates could erode some of the advantages that utility stocks have enjoyed. The benchmark 10-year Treasury yield shot up to as high as 2.63% in mid-September from a low of 2.33% in late August amid expectations that the Federal Reserve will start raising borrowing costs in the middle of next year. The yield currently stands at around 2.44%.

Higher yields would make utilities' dividend yields -- currently about 4% -- less attractive in comparison to Treasuries.

"For the last five years, all you had to do was buy a basket" of utility stocks, said Mario Gabelli, CEO of GAMCO Investors. "For the next five years, you want to be more selective."

The utilities sector stood at No. 12 out of the 33 sectors tracked by IBD as of Friday. Of the four utility subgroups, only the electric power group ranks in the top half of IBD's 197 industry groups. The other groups are diversified, gas distribution and water supply.

Gabelli said he prefers companies with assets in the natural gas business and those engaged in financial engineering -- such as those buying companies and splitting them up.

National Fuel Gas ( NFG ),NextEra Energy ( NEE ) andEnergy Transfer Equity LP ( ETE ) are the top holdings in the Gabelli Utilities Fund , which has $3.5 billion in assets.

Of those, Energy Transfer Equity, which operates oil and natural gas pipelines and storage facilities, has the highest IBD Composite Rating. The stock has risen 45% this year, easily outpacing the S&P 500's 5% gain.

Energy Transfer's long-term dividend growth rate is 8%. And its annual dividend of $1.52 a share yields 2.6% at the current share price, also well above the S&P 500 average.

Many analysts consider utilities stocks to be overvalued because they've already enjoyed strong advances. They say higher interest rates would dent their appeal.

Yet Ed Perks, who manages $97 billion Franklin Income Fund , said utility stocks remain a "great match" with an income strategy.

"There's a pretty wide range of companies today in the utility sector that are pretty yield-oriented and are attractive because of how stable that yield is," he said.

He said utilities that have the highest earnings potential will be in the best position to withstand higher interest rates and raise dividends over time.

He noted thatNextEra Energy ( NEE ) rose 24% andSempra Energy ( SE ) climbed 30% in 2013 despite strong gains in the 10-year Treasury yield sparked by expectations that the Fed would boost interest rates sooner than expected. By contrast, utility stocks that had lower growth profiles were impacted a little more, he said.

Perks said he expects "modestly higher" yields of about 3% to 3.25% on the 10-year Treasury. "Companies that are growing dividends will still be an attractive place to invest in," he added.

The top holdings in Franklin Utilities Fund includeEdison International ( EIX ), NextEra,Duke Energy (DUK) and Sempra Energy.

John Kohli, who manages the $5.8 billion fund, said Duke Energy is in "good growth territories" such as the sunbelt states of Florida and the Carolinas, where there's "fairly good customer growth." "It's a company that looks in our mind to have a bright future," he said.

Duke has a three-year earnings growth rate of 1% but a 27% revenue growth rate over that time.

Profit this year is seen rising 6%, followed by a 4% increase in 2015.

The company has increased its dividend for 10 straight years. The annual payout of $3.18 a share yields 4.2% at the current share price.

Sempra Energy is investing in Liquefied Natural Gas infrastructure and is also pursuing wind power and solar power projects in the Southwest, Kohli said.

"The industry has been very proactive in getting ahead of the regulatory process," Kohli said, adding that there's "a lot of growth coming out of meeting compliance."

Utility stocks got a vote of confidence Sept. 10, when Charles Munger, vice chairman of Warren Buffett's Berkshire Hathaway conglomerate, said Berkshire will greatly expand investment in utilities companies with the aim of becoming the biggest utilities business in the U.S. Munger said he expects to earn 8% to 9% on the investments.

"The chance that we won't have a good return in that investment is practically zero," the Wall Street Journal quoted him as saying at the annual meeting of the Daily Journal.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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