Grappling with Externalities

The yield on the 10-year Treasury note has surged to more than 2.4 percent after bottoming at 1.65 percent on Jan. 30, 2015. And with all eyes on when the Federal Reserve will raise interest rates, Treasury yields likely will head higher.

Does an uptick in interest rates from the ultra-low levels that have prevailed in recent years really matter for the names in our Utility Report Card?

In May 2015, essential-service companies with credit ratings ranging from BBB to A- had no problems issuing 30-year debt at coupon rates that hovered around 4 percent. Institutional investors whose mandates include a heavy fixed-income component still snap up whatever corporate bonds come to market.

Regardless of the uptick in Treasury yields, the names in our coverage universe still enjoy a historically low cost of capital and continue to shore up their balance sheets by refinancing debt and extending maturities.

Whereas higher yields on the benchmark 10-year Treasury bond haven’t dramatically affected utilities’ cost of capital, this move has affected investor sentiment and given them an excuse to take profits.

(Click graph to enlarge.)

The Dow Jones Utilities Average has tumbled 10.2 percent since the end of January, while the Alerian MLP Index has given up about 2.4 percent of its value. Although the S&P 500 Telecommunication Services Index and the Bloomberg North American Power Yieldco Index have generated positive total returns year to date, both indexes have pulled back in recent weeks.

First-quarter results posted by the companies in our coverage universe largely lived up to expectations, but equity performance sometimes diverges from fundamentals. Our graph demonstrates that the conventional wisdom about dividend-paying stocks and interest rates is alive and well.

Investors rush to sell dividend-paying stocks when they become worried about rising interest rates, creating a self-fulfilling prophecy that ostensibly confirms these equities’ sensitivity to interest rates.

History tells a different story. “A Question of Correlation” quantifies the extent to which movements in the Dow Jones Utilities Average correlate with the S&P 500 and the yield on 10-year Treasury bonds over various time periods. Note that higher R-squared values—a statistical measure of correlation—indicate a closer relationship between the two indexes being compared.