With the Federal Reserve having raised interest rates three times in the past 16 months and with the stage set for rate hikes later this year, the utilities sector is performing surprisingly well. For example, the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, is up 6.8% this year.
As the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
No sector is as negatively correlated to rising interest rates as utilities, meaning the longer the Fed resists raising interest rates, the longer high-yielding utilities stocks and ETFs remain compelling destinations for yield-starved investors.
“Utility stocks have acted much better than expected this year, up 6%, which is slightly better than the S&P 500. In a new research report, Deutsche Bank remains very selective on the industry and carefully raised the price targets on five stocks that are rated Buy,” reports Lee Jackson for 24/7 Wall Street.
XLU and rival utilities ETFs languished on the basis that fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing.
The bond-esque utilities sector has also weakened alongside the fixed-income market as Treasury yields rose on the Fed outlook and inflationary pressures.
Utilities stocks and ETFs are extremely sensitive to changes in interest rates. Still, some investors see opportunity with rate-sensitive assets such as XLU and real estate ETFs, noting that 10-year yields are overbought and sentiment against the likes of XLU is at bearish extremes, which could create opportunity from the long side with the utilities sector.
One of the utilities Deutsche is bullish on is American Electric Power Co. Inc. (NYSE: AEP), the sixth-largest holding in XLU. American Electric Power commands a weight of just over 5.1% in the benchmark utilities ETF.
The company “ranks among the nation’s largest generators of electricity, owning nearly 38,000 megawatts of generating capacity in the United States. It also owns the nation’s largest electricity transmission system, a more than 40,000-mile network that includes more 765 kilovolt extra-high voltage transmission lines than all other U.S. transmission systems combined,” according to 24/7 Wall Street.
For more information on defensive ETFs, visit our defensive ETF category.