While the performance of the technology sector indicates risk appetite is prevalent in financial markets this year, some investors still prefer defensive sectors. That much is confirmed by a year-to-date surge of over 13% for the Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund.
As is widely known, the Federal Reserve holds its July meeting this week. Fed meetings can potentially put focus on rate-sensitive asset classes and sectors, including utilities. XLU yields about 3.3% on a trailing 12-month, making it and rival utilities ETFs popular alternatives to lower-yielding bond funds. The sector, one of the smallest sector allocations in the S&P 500, is also one of the least volatile.
“Remember, Treasury yields and utilities are normally inversely related. Higher interest rates make utilities comparatively less appealing in terms of dividend yields. Thus, investors generally offload stocks when interest rates go up,” reports Market Realist. “Higher interest rates are also expected to dent utilities given their heavy capital-expenditure requirements. Utilities usually carry large amounts of debt on their books, and higher interest rates increase their debt-servicing costs, ultimately hurting profitability.”
As the Fed continues raising 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.