Lagging REIT & Utility ETFs At Crossroad

February 27, 2018

The stock market is on the mend. After witnessing its worst correction in two years earlier this month, the S&P 500 has shot back up during the past two weeks. From a low of 2,533 on Feb. 9, the index recovered to 2,780 on Feb. 26, putting it up a solid 4.3% for the year.

The interest rate fears that spurred the most recent convulsion in the stock market still linger, but they’ve diminished as the yield on the U.S. 10-year Treasury bond slipped from 2.95% at its high to around 2.87% currently.

Yet while the overall stock market has brushed off interest rate worries for now, two sectors are still paying close attention to every tick in the Treasury market―utilities and real estate.

The $6.7 billion Utilities Select Sector SPDR Fund (XLU) is down 4.7% this year, while the $2.5 billion Real Estate Select Sector SPDR Fund (XLRE) is lower by 6.5%.

YTD Returns For XLU, XLRE, SPY


Considered two of the most interest-rate-sensitive sectors, utilities and real estate have struggled as the benchmark U.S. 10-year Treasury bond yield has climbed almost half a percentage point from 2.41% at the start of 2018.

Both sectors were popular during the past few years as interest rates fell to ever-lower levels, prompting income investors to stretch for yield. Now that rates are rising, some of those same investors are selling first and asking questions later.

Bond Substitute

“The utility market has been very much moving in lock step with the 10-year Treasury,” said John Bartlett, portfolio manager and utility analyst for Reaves Asset Management, the issuer of the actively managed Reaves Utilities ETF (UTES).

Bartlett says that the correlation between utilities and the 10-year Treasury is extremely strong on a day-to-day basis, even going as far as to call utilities a “bond substitute.”

Currently, XLU, which tracks all the utility stocks within the S&P 500, is yielding 3.5%, or 0.65% more than the 10-year Treasury.

In his view, utilities will continue to track the Treasury market short term: “If you think interest rates are going to turn down sharply, utilities will work pretty well from here, but if you think interest rates are going up, that’s going to be a real head wind,” Bartlett explained.

For investors without a strong opinion on where Treasuries are going―Bartlett counts himself among them―the best course of action may be to focus on the long term. He says the correlation between the 10-year Treasury and utilities is much weaker over long-term time periods because utilities have the ability to grow their dividends year after year, through good times and bad.

In fact, as long as interest rates don’t spike up too far and too fast, utilities could overcome higher rates with earnings and dividend growth. But if rates spike dramatically in short order (to 4.5% this year, for example), then growth “isn’t going to bail you out,” Bartlett warned.

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