Why Utilities Could Underperform Despite Their Dip

Capital needs and debt

Both utilities (IDU) and telecom need heavy investment in infrastructure, which means they have huge capital needs. This is why they tend to have a high amount of debt in their books. REITs (VNQ) also have a high amount of capital needs.

Why Utilities Could Underperform Despite Their Dip

High dividend–paying sectors are highly leveraged

The graph above shows the debt-to-equity ratio for various sectors. A higher debt-to-equity ratio indicates higher leverage. As you can see, both utilities and telecom have very high levels of leverage. The utility sector (XLU) has a debt-to-equity ratio of 125%, compared to the close to 200% of telecom. Technology stocks (IYW) have the least debt compared to equities and are well poised to navigate through the higher rates phase.

Meanwhile, dividend-paying sectors like utilities and telecom could see their margins compress as interest rates rise. This is because they would need more funds to service debt due to the colossal amount of debt.

Treasury yields had plummeted to sub-2% levels earlier this year, which led to a flight to bond-proxies like utilities, earlier this year. In January, the utility sector was trading at a 5% premium to the broader market. Prior to the Great Recession, utilities traded at a 25% discount. That discount reflected the slower growth characteristics of the industry. The premium in January, on the other hand, was a result of investors seeking investments that can offer higher yield. However, multiples in the sector have contracted since, restoring some value in the segment.

Why Utilities Could Underperform Despite Their Dip

Utilities could underperform the broader markets going forward

This second graph compares the PE (price-to-earnings) ratios of the utilities sector with that of the S&P 500 (SPY). Utilities appear expensive relative to historic valuations. The utilities sector is currently trading at a discount of 13%, compared to ~15% historically.

Investors need to be wary of dividend stocks, as they still appear pricy, given that interest rates should rise over the next few years. That said, the hike will likely be gradual.

However, with equities facing a number of headwinds, expect a good portion of US equity returns to come in the form of dividend yield.

Read Where Dividend Investors Are Seeking Income for more on investing in dividend stocks.