ETF Trends
ETF Trends

Perhaps it was a case of responding to higher interest rates or investors looking for sectors with more attractive valuations, but the Utilities Select Sector SPDR (NYSEArca:XLU), the largest utilities sector exchange traded fund, fell almost 4% over the past month.

Some market observers believe the sector, prized for its high dividend yield and defensive traits, can keep delivering upside as 2017 moves along. XLU is showing its rebound potential with a gain of more than 1% over the past week.

“Due to the utility sector’s regulated nature, utility companies do not enjoy a high profit margin. However, they are usually able to generate a steadily increasing profits. As such, their stock prices are generally more stable than the broader market. In fact, the ETF has a beta of 0.54 when compared to S&P 500,” according to a Seeking Alpha analysis of XLU.

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.

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.

“Because utility companies tend to offer a stable dividend, it is often seen as a bond-like stocks. As interest rate hikes, many are concerned whether the stock prices of these companies will fall or not. While the stock prices of utility companies will inevitably be pressured, historical record shows that these stocks do continue to grow,” according to Seeking Alpha.

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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.

Year-to-date, investors have pulled $112.7 million from XLU, but the ETF has seen inflows of $205.5 million to start the third quarter.

For more information on defensive ETFs, visit our defensive ETF category.