Due to the capital intensive nature of the business, utilities stocks and ETFs make for predictable victims when interest rates rise. Higher interest rates for utilities mean higher borrowing costs, in theory meaning bad news for a sector that is home to some companies with already large debt loads.
Price action in utilities ETFs confirmed the group’s vulnerability to rising rates as those funds were the hardest hit sector play over the second quarter on rising interest rates and Federal Reserve tapering speculation. From its May closing high of $40.71 to its June nadir of $36.44, the Utilities Select Sector SPDR (NYSEArca: XLU) lost 10.4%. [Rising Rates Sting Utilities ETFs in Q2]
XLU is sitting on a three-month loss, but the fund has perked over the past four weeks, gaining 3.3 percent to reclaim nearly all of its May/June tumble. XLU and rival ETFs have traded higher as 10-year Treasury yields have declined, but even at Monday’s close of 2.57%, 10-year yields are still 38 basis points above where they were on June 17. [Utilities ETFs Vulnerable to Rising Rates]
Utilities ETFs rising over the past four weeks may also be a sign that either investors do not believe interest rates will spike in the near-term or that worst possible interest rate scenario is already priced into the utilities sector. That is not out of the realm possibility when looking at XLU’s rivals.
The Vanguard Utilities ETF (NYSEArca: VPU) is up 3.7% in the past month and is in the green over the past 90 days while XLU is not. The iShares Utilities ETF (NYSEArca: IDU) gained 1.7% on 15 times its average daily volume Monday. With that, IDU has climbed 3.6% over the past three months and now rests about $2 from its May peak.
There is still some risk involved with utilities ETFs. The aforementioned funds have been among income investors’ favorite sector bets in recent years because of dependable dividends and solid, Treasury-thumping yields. However, future dividend growth from the sector has the potential to disappoint.