Cloud Looms Over Surging Utility ETFs

August 30, 2017

Utilities Yield/Treasury Yield Spread

 

Big Risk To Consider

Looking ahead, gains in utilities may not be as easy to come by. Guggenheim's Pourreza expects the rally to continue, but cautions that it is "in the 9th inning." He says macro factors will drive the sector more than anything.

Meanwhile, the Morgan Stanley analyst team covering utilities rates the sector as "in line,"
but points to one distinct downside risk that investors should be cognizant of.

In a report dated Aug. 15, the analysts wrote: "A potential element of tax reform that is, in our view, completely off the radar and should not be is the House proposal to reduce the tax rate on interest income from 43% to 16.5% for individuals in the highest tax bracket."

The report mentions that, based on the House proposal, taxes on dividends would move from 23.8% to 16.5% for individuals in the highest tax bracket. The smaller reduction for dividend taxes is "a distinct macro negative for utilities relative to taxable bonds," said Morgan Stanley analysts.

Valuation Advantage?

They argued that the much more significant reduction in the tax rate for interest income compared to dividend income would lead to a substantial valuation advantage for bonds compared to utilities.

According to the report, utilities are currently yielding 0.13% less than corporate bonds on an after-tax basis, compared to the 0.50% historical average. That means utilities currently "screen attractive relative to fixed-income investment opportunities on an after-tax basis."

However, "the tax reform proposals in the House Blueprint would flip this relationship, resulting in utility after-tax dividend yields trading at 1.07% below corporate bond yields, well in excess of the 0.50% average," the analysts continued.

“To bring the spread down to the long-term historical average, utility stock prices would need to decline by about 20% (or bonds would need to rise in value by a similar amount)," they concluded.

Contact Sumit Roy at [email protected].

 

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