Utility ETFs & Rising Interest Rates

Utilities exchange traded funds were the hardest hit sector play over the second quarter on rising interest rates and Federal Reserve tapering speculation.

Since the start of April, the Select Sector SPDR Utilities (NYSEArca: XLU) has declined 4.0%, Vanguard Utilities ETF (NYSEArca: VPU) fell 3.5% and iShares Dow Jones U.S. Utilities (NYSEArca: IDU) dipped 3.2%. In comparison, the S&P 500 index has gained 2.9%.

Over the second quarter, yields on the benchmark 10-year Treasury note has increased about 60 basis points and now hovers at 2.48%, pressuring utility stocks.

“Rising interest rates can hamper these firms’ profitability because regulated rates of return are not frequently adjusted,” according to Morningstar analyst Robert Goldsborough.

“While the average rate of return that regulators currently grant utilities is near its lowest level in 20 years, it is still high relative to long-term interest rates,” Goldsborough added. “According to our utilities analysts, if the spread between the average target return and the 10-year Treasury rate reverts to its 20-year mean of 6%, earnings for many utilities could fall 10%-20%.”

Moreover, in a growing U.S. economy, investors are more likely to turn down traditional defensive plays, like utilities, in favor of more riskier cyclical sector investments. [iShares: The Case for Rotating into (Select) Cyclical Sectors]