Investors who believe volatility may persist through the year and the Federal Reserve may hold off on quick interest rate hikes may want to take a second look at defensive utilities sector exchange traded funds.
“For investors who hold a contrarian view on the U.S. Federal Reserve’s future actions on interest rates, a utilities-sector investment could make some sense,” writes Morningstar equity strategist Robert Goldsborough.
The utilities sector fundamentals remain strong. However, utilities have been underforming due to the sector’s inverse relationship to rising interest rates – when rates rise or investors fear higher rates, utilities typically underpeform, and vice versa.
Most investors view utilities as a reliable, income-generating asset that exhibit some bondlike characteristics. As interest rates declined, the sector appealed to many income investors for its relatively higher yields. For instance, the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector ETF play, has a 3.67% 12-month yield.
However, as interest rates rise, yield investors will likely sell riskier dividend-yielding equities, like utilities, for more attractive fixed-income securities. Moreover, higher rates means utilities will face stiffer borrowing costs to fund growth, which would dampen earnings.
Consequently, with global volatility elevated and U.S. growth slowing down, many believe the Federal Reserve may follow a more gradual interest rate hike schedule. Without the Fed to support higher Treasury yields, utilities may have a chance to turn around this year.