Utilities Sector

The utility sector is a category of stocks for companies that provide basic services including water and sewage services, electrical power transmission, airports, dams, and natural gas delivery. Utilities earn a profit but are a public service and as a result, are heavily regulated.

Typically, investors buy utilities for long-term holdings that provide income and stability.

Utilities typically offer investors stable and consistent dividends as well as less price volatility relative to the overall equity markets. Because utility stocks are considered stable and pay a consistent dividend, they tend to perform well when the economy is in a recession and be out of favor with the market during times of economic expansion.

There are many types of utilities for investors to consider. Large utility companies might offer multiple services such as electricity and natural gas. Other utilities might specialize in one service such as water. Some utilities use renewable energy including wind and solar to produce electricity. Investors can purchase regional utilities or invest in exchange-traded funds (ETFs) that contain a basket of many utility stocks throughout the U.S.

Utilities require a significant amount of expensive infrastructure and as a result, carry large amounts of debt on their balance sheets. High debt loads make utilities sensitive to changes in the market interest rate.

Because utilities are capital-intensive, they need a continuous inflow of funds to make infrastructure upgrades and purchase new assets. Utilities generate operating income and earn a profit. However, that profit is limited due to regulatory constraints on pricing services to the consumer. Due to the high cost of infrastructure and the limits placed by regulatory bodies, utilities must turn to external funding sources for financing capital projects and improvements.

The significant debt load also results in high utility debt-to-equity (D/E) ratios, which can impact companies’ credit ratings. The D/E is the amount of money left after accounting for all debt that would be returned to shareholders in the case of a bankruptcy. Since utilities carry high debt loads this can adversely affect their credit ratings, making it difficult to borrow funds and increasing their cost of operations.

Because many states let consumers move from one utility operator to another, consumers typically choose the least expensive operator in the area. Higher-cost producers are eventually eliminated from the market unless they can cut their costs.

Long-term power purchase agreements between companies and consumers also impact profits. When utility generation costs increase, companies must continue to honor the contract agreements and sell utilities at the agreed upon, preset rate, which decreases their profits.

Because utility stocks pay reliable dividends, they often compete with equities that pay lower dividends as consumer investment options. After the financial crisis of 2008, the Federal Reserve cut interest rates to stimulate the economy causing investors to rush to utilities for their yield and safety. In short, utility companies benefited as a defensive choice for investors since the sector is a defensive play against macroeconomic downturns.

However, as the economy improves and interest rates rise, investors can find higher-yielding alternatives than utilities. As rates rise, so too do U.S. Treasury yield and given the safety of bonds, investors can invest in bonds, get paid an attractive yield, and have the safety that comes with the government backing of Treasuries.

For example, if a utility pays a dividend yield of 3%, but interest rates increase pushing bond yields to 4%, the utility company would have to increase their dividend payout to match the rising yields of Treasuries. As a result, utilities tend to do well when interest rates decrease because their dividend is more attractive—or higher than—Treasury yields. However, as the economy improves, utilities tend to sell off as interest rates rise back to normal levels and their dividends are lower—or less attractive than—Treasury yields.

Utilities are stable investments that provide a regular dividend to shareholders making them a popular long-term holding option. Dividends yields are usually higher than those paid by other stocks. During times of economic downturns or with low market interest rates, utilities provide a stable, haven investment. Investors may invest in utility company shares, industry sector ETFs, and in utility bonds or other debt securities.

The utility sector has intense regulatory oversight since they provide for the basic needs of civil society. This oversight makes it difficult for them to raise rates to increase revenue. The sector requires expensive infrastructure that needs regular updating and maintenance. To meet these infrastructure needs the utility will float debt products that, in turn, increase their debt loads. This debt also makes these services particularly sensitive to interest rate risk. Should rates rise, the company must offer higher yields to attract bond investors, driving up their costs. 

Investors can buy into individual utility stocks or bonds, or they can invest in ETFs that are comprised of a basket of many utilities.

For example, the Utilities Select Sector SPDR Fund (XLU) is one of the largest utility sector funds with $9 billion in assets under management. The ETF also is one of the most actively traded utility ETFs with more than 10 million shares traded daily. The fund typically pays a dividend yield of around 3% with a low expense ratio of 0.13%.

In comparison, the XLU's dividend yield beats out the yield for the S&P 500 equity ETF—SPDR S&P 500 Trust ETF (SPY)—that pays around 1.86%.

Further, if the benchmark 10-year Treasury yield trades below 3%, investors might consider buying the utility sector through the XLU or individual stocks. It's important to check with your broker for current market pricing since Treasury yields, and dividend yields for both utilities and equities change with market conditions.