Utility Stocks Provide the Best Defense

The strength exhibited by utility stocks lies in a growing comfort level on the part of many investors, who rightly see an industry that’s de-leveraged and de-risked dramatically since late 2002.

— Roger Conrad, Big Yield Hunting

Investors are clearly in “risk-off” mode, so it’s surprising that traditionally defensive sectors such as utilities have received little attention from the market. The upshot is that this neglect created an excellent opportunity for risk-averse investors.

As equities approach bear market territory, investors have piled into traditional safe havens, such as gold and Treasury bonds, driving them to record highs. But utilities may actually benefit the most from the current economic environment.

The numerous electric utilities that rely on natural gas as their primary fuel for power generation have benefitted from rock-bottom natural gas prices, which have been depressed since 2008. A glut of supply resulting from development of the Marcellus Shale formation, as well as the Eagle Ford and Bakken Shale formations, has put heavy downward pressure on natural gas prices. As such, natural gas-reliant electric utilities have enjoyed extremely low costs of generation.

Additionally, utilities will likely benefit from the latest move by the Federal Reserve to stimulate borrowing. Under “Operation Twist,” the Fed plans to sell the shorter-term bonds on its balance sheet and use the proceeds to buy bonds with maturities of greater than six years. The Fed’s goal is to drive down long-term interest rates to reduce the costs of borrowing for businesses and consumers.

That should be a boon to utility companies, which will be able to secure long-term financing at extremely attractive rates. Cheap financing will allow utilities to invest in plant and distribution structure upgrades that were delayed after the 2008-09 financial crisis struck. And utilities that operate in regulated markets will have little trouble passing those costs along to consumers.

Utilities Select SPDR (NYSE: XLU) tracks the 33 utilities on the S&P 500 by using a market-capitalization weighted index. That means the larger the utility’s market cap, the heavier it’s weighting in the exchange-traded fund (ETF). The one drawback to that approach is that the ETF’s top-10 positions account for more than 56 percent of assets.

The composition of the EFT’s index rarely changes, so its portfolio experiences very little turnover—it currently averages about 10 percent annually. This low turnover makes Utilities Select SPDR extremely tax efficient.

The ETF tracks utilities of all stripes, including gas utilities, independent power producers and energy traders. But electric utilities comprise the majority of the ETF’s holdings at almost 54 percent of assets. It also holds a mix of both regulated and unregulated utilities.

But the ETF’s two most impressive attributes are a low 0.20 percent expense ratio and an attractive 4.1 percent yield. The low expense ratio makes Utilities Select SPDR a cost-effective, long-term holding.

Furthermore, the dividend yield should be easily maintained. During the last recession, about two-thirds of electric utilities that operated in regulated markets were able to increase their dividends due to stable markets and low leverage. Utilities Select SPDR’s dividend yield should compensate investors nicely while they wait for the market’s volatility to subside.