This post is in response to a reader’s request. Specifically, the reader asks (I'm paraphrasing) for some explanation as to why even if a stock (i.e., a safe utility) has a dividend above average (e.g., 5%), it is probably still going to take a hit when U.S. Treasury rates rise. The inquiry continues that this is in light of prevailing rates currently being under 3%.
This is a great question. Before we can attempt to answer it, though, we have to challenge the assumption that rising Treasury rates will indeed probably negatively impact a high dividend stock like a utility. Looking back at some historic correlations* using Bloomberg, I see that since January 2000 (nearly 14 years) there is not a strong relationship between utility stocks and U.S. Treasury rates. And that relationship is actually a positive correlation in many cases meaning that when one is up the other is up slightly as well. This lack of a relationship between the two breaks down even more when we look back 24 years to January 1990.
A lack of correlation isn’t surprising. There are a lot of factors that affect these financial instruments. And lost in that noise is the fact that interest rates do most likely have a negative relationship with high-dividend paying stocks. And notice that my quick-n-dirty correlation analysis compares utility indices and not necessarily high-dividend stocks—I was assuming that commonality, but it is a fair assumption. Below is the case for why rising rates might be bad for a theoretical high-dividend utility stock. But keep in mind an important question is why are interest rates rising when they rise. Is economic growth improving? Are inflation expectations increasing? Are the bond vigilantes finally saying they've had enough?
1. High CAPEX: Utility companies have high rates of capital investment. Higher prevailing interest rates (ceteris paribus) imply higher costs; hence, lower profits.
2. Increasing Inflation Expectations: Utilities may have a poor ability to pass on inflation to customers. At best rate increases come with a lag as they wind their way through the political process. If rates are rising because inflation expectations are rising, then that implies lower profitability for the price-restrained utility.
3. Investor Demand: This gets to the heart of the case. The attractiveness of a specific source of yield is relative (and inverse) to the competitive market for yield regardless of how much higher or lower the specific yield in question is. If I give you $100 for the promise that you will pay me $5 per year forever, that promise is worth less when the going rate of such promises rises from $3 per year to $4 per year. I used to have an asset (the promise) that was worth $167 in the open market (present value of 5% interest on $100 when rates are at 3%) but is now only worth $125 (present value of 5% interest on $100 when rates are at 4%). This relative yield component of the theoretical utility stock's price implies another reason rising rates might be negative for the stock . . .
4. Improved Economic Prospects/Alternative Investments: If rates are rising because economic growth is improving, then a lot of investment opportunities start looking better as compared to the utility stock. Just as alternative forms of direct yield (such as dividends or interest) impact the stock’s value, so do prospects for indirect yield (such as price appreciation). The utility has less uncertainty regarding its future value—that's why it can be a good investment in downturns. However, that lack of uncertainty caps the upside as well. Whereas, the high-risk tech startup firm has relatively high uncertainty positioning it to benefit when future prospects improve.
This is not investment advice. I do not directly have a long or short position on utilities; nor do I have a prediction as to what the future holds for them.
*I compared the S&P Mid-Cap Utility and S&P 500 Utility indices with 3-month, 3-year, 5-year, 10-year, and 20-year constant maturity U.S. Treasury series using both weekly and monthly correlation calculations.
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