Cloud Looms Over Surging Utility ETFs

The stock market may have hit a road bump in the month of August, but one sector has quietly bucked the trend.

Geopolitical tensions surrounding North Korea and fading optimism about tax reform weighed on the S&P 500 during the month, yet those same factors helped power utility ETFs to a new all-time high.

Utilities are currently the third-best-performing stock market sector of 2017, behind only technology and health care. The Utilities Select Sector SPDR Fund (XLU) has returned 15.5% in the year-to-date period through Aug. 28, compared with the 10.4% gain for the SPDR S&P 500 ETF Trust (SPY) in the same time frame.

YTD Returns For XLU, SPY

Risk-Off

A combination of "low yields and a risk-off market" is supporting the rally in utilities, according to Shar Pourreza, a utilities analyst at Guggenheim Partners. According to Pourreza, a lot of investors are nervous about the "the general market valuation, U.S. policy inertia, and geo-global macro concerns."

Considered a safe-haven sector, utilities tend to outperform when investors are jittery. They also offer large dividends―the aforementioned XLU was last yielding around 3.2%, compared with 1.9% for SPY. That makes them great for investors seeking income, but also makes them interest rate sensitive.

Utilities are often valued based on bond yields. When bonds climb and interest rates fall―as they typically do when investors are nervous―utilities become more attractive (and vice versa). The benchmark U.S. 10-year Treasury yield briefly fell to 2.08% Tuesday, a nine-month low, and well below the 2.44% level at which it started the year.

The current spread between Treasury yields and utility yields is 1.06% in favor of utilities, equal to average of the past decade.

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].