Utility stocks in a time of rising rates
Stability, cash flow counterbalance price swings
Tech stocks have been getting a lot of media attention. But the real concern for income investors should be what has happened in the utility sector recently. After starting the year strongly, the S&P/TSX Capped Utilities Index went into a slide in late January. It rallied back but is still down 5.8% from its high of Jan. 25.
But others have been hit hard. Brookfield Renewable Partners (TSX: BEP.UN) is off 20% since the start of the year. Algonquin Power & Utilities Corp. (TSX: AQN) has dropped 11.2% year to date, and Northland Power Inc. (TSX: NPI) is down 16%. This is not the type of performance we expect from these normally stable stocks.
The lingering effects of Covid played a role by reducing industrial demand for the gas and electricity these companies provide. The Texas winter storm that played havoc with that state’s electricity grid early in the year also hit some companies, including Algonquin, which saw output drop at its wind farms in that state due to ice and freezing conditions. The company issued a statement saying it expects to take a hit of between $45 million and $55 million on this year’s adjusted EBITDA.
Green utilities, including Brookfield, Algonquin, and Northland, also saw prices run ahead of themselves in recent months, so part of their retreat is a normal correction.
But the main culprit weighing on utility share appears to be interest rates. Utilities are highly interest rate sensitive, for two reasons. First, they carry a heavy debt load. This is a capital-intensive industry, with companies investing billions each year to maintain and expand infrastructure. When rates rise, so eventually do their debt-servicing costs.
Second, utility stocks tend to trade on yield. Because most of their income is regulated, capital gains potential is limited. Investors buy the shares for stability and cash flow. When bond yields rise, as they have been doing in recent weeks, investors demand a higher spread to accept the added stock market risk. That results in downward pressure on utility stocks, which pushes yields higher.
For example, Northland Power pays a monthly dividend of $0.10 per share ($1.20 per year). At the early February price, that produced a yield of 2.36%. Now, with the price drop, it is up to 3.17%. That’s the impact rising interest rates can have.
We’re likely to experience more of the same in the months to come. The Bank of Canada and the U.S. Federal Reserve Board have both said they will continue to keep their key lending rates low until a full economic recovery is underway. But investors, fearful of inflation from loose fiscal and monetary policies on both sides of the border, are undermining their efforts by pushing commercial rates higher.
If this continues, and it probably will, it will put more downward pressure on utilities.
What should you do? Hold and buy more as share prices drop. These stocks provide cash flow and stability to a portfolio. They are all solid companies that will continue to raise their dividends year after year.
You don’t buy them for capital gains, so don’t let any price declines upset you. Utilities will always have a place in any income portfolio.
Gordon Pape is one of Canada’s best-known personal finance commentators and investment experts. He is the publisher of The Internet Wealth Builder and The Income Investor newsletters, which are available through the Building Wealth website.
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