The Utilities Select Sector SPDR (NYSEArca: XLU), the largest utilities sector exchange traded fund, labors almost 11% below its 52-week with much of the ETF’s woes being seen late in the fourth quarter and early this year.
Rising interest rates and tax reform are among the issues that hindered the utilities sector in late 2017.
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. The Fed raised interest rates in December, its third such move in 2017 and several more rate hikes are forecast for 2018.
Additionally, the utilities sector has not gotten much of a boost from tax reform. On the note of tax reform, the benefit to utilities is muted because, as regulated industry, utilities will be forced to pass cost savings from tax reform onto consumers.
“The Tax Cuts and Jobs Act signed into law on Dec. 22, 2017 has negative credit implications for U.S. regulated utilities and utility holding companies over the short-to-medium term,” according to Fitch Ratings. “A reduction in customer bills to reflect lower federal income taxes and return of excess accumulated deferred income taxes is expected to lower revenues and funds from operations (FFO) across the sector. Absent mitigating strategies on the regulatory front, this is expected to lead to weaker credit metrics and negative rating actions for those issuers that have limited headroom to absorb the leverage creep.”
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.
“Over a longer-term perspective, Fitch views tax reform as modestly positive for utilities. The sector retained the deductibility of interest expense, which would have otherwise significantly impacted cost of capital for this capital-intensive sector,” said the ratings agency. “The exemption from 100% capex expensing is also welcome news for the sector, which has seen years of bonus depreciation reduce rate base leading to lower earnings. Finally, the reduction in federal income taxes lowers cost of service to customers, providing utilities headroom to increase rates for capital investments.”
For more information on defensive ETFs, visit our defensive ETF category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.