Tech stocks have been getting a lot of media attention. But the real concern for income investors should be what has happened in the utility sector recently.
After starting the year strongly, the S&P/TSX Capped Utilities Index went into a slide in late January. It rallied back last week but is still down 5.3 per cent from its high of Jan. 26.
But others have been hit hard. Brookfield Renewable Partners LP (BEP.UN-T) is off 18 per cent since Jan. 26. Algonquin Power & Utilities Corp. (AQN-T) has dropped 12.2 per cent since mid-February. Northland Power Inc. (NPI-T) has given back 11.7 per cent since Feb. 5. This is not the type of performance we expect from these normally stable stocks.
The lingering effects of COVID-19 played a role by reducing demand from industry for the gas and electricity these companies provide. The Texas winter storm that played havoc with that state’s electricity grid also hit some companies, including Algonquin, which saw output drop at its wind farms in that state owing to ice and freezing conditions. The company issued a statement saying it expects to take a hit of between $45-million and $55-million on this year’s adjusted EBITDA, or earnings before interest, taxes, depreciation and amortization.
Green utilities, including Brookfield, Algonquin and Northland, also saw prices run ahead of themselves in recent months, so part of their retreat is a normal correction.
But the main culprit weighing on utility shares appears to be interest rates. Utilities are highly interest rate sensitive, for two reasons. First, they carry a heavy debt load. This is a capital-intensive industry, with companies investing billions each year to maintain and expand infrastructure. When rates rise, so, eventually, do their debt-servicing costs.
Second, utility stocks tend to trade on yield. Because most of their income is regulated, capital gains potential is limited. Investors buy the shares for stability and cash flow. When bond yields rise, as they have been doing in recent weeks, investors demand a higher spread to accept the added stock market risk. That results in downward pressure on utility stocks, which pushes yields higher.
For example, Northland Power pays a monthly dividend of 10 cents a share ($1.20 a year). At the early February price, that produced a yield of 2.4 per cent. Now, with the price drop, it is up to 2.7 per cent. That’s the impact rising interest rates can have.
We’re likely to experience more of the same in the months to come. The Bank of Canada and the U.S. Federal Reserve Board have both said they will continue to keep their key lending rates low until a full economic recovery is under way. But investors, fearful of inflation from loose fiscal and monetary policies on both sides of the border, are undermining their efforts by pushing commercial rates higher.
If this continues, and it probably will, it will put more downward pressure on utilities.
What should you do? Hold and buy more as share prices drop. These stocks provide cash flow and stability to a portfolio. They are all solid companies that will continue to raise their dividends year after year.
You didn’t buy them for capital gains so don’t let any price declines upset you. Utilities will always have a place in any income portfolio.
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