Hydro One’s dividend yield is curiously low. Here’s why that could be a problem

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We’ve all been warned that some dividend yields can be too high, signalling that a payout is in danger of being cut. But can a dividend yield be too low?

It’s an important question in the case of Hydro One Ltd. H-T, the Toronto-based utility whose yield dipped to about 3 per cent – a record low – over the past couple of months as the share price rallied.

The shares ended the week at $35.86, leaving the dividend yield at 3.1 per cent – still oddly low for a regulated utility, one that often yielded more than 4 per cent before the pandemic.

After holding the stock for years, I sold my shares in late November, when the shares rallied above $36. My reasoning was hardly complex: Why take a chance on Hydro One when I can get a bigger yield on other stocks, guaranteed investment certificates and even money market funds?

The bullish case for Hydro One is, admittedly, compelling.

Central banks have been raising interest rates aggressively over much of the past year in a battle against high inflation, and this tighter monetary policy is threatening to tip the economy into recession.

The U.S. bond market, where yields on 10-year Treasury notes are lower than yields on three-month bills – an unusual situation known as an inverted yield curve – offers a powerful indicator that a recession is indeed brewing.

Utilities can sail through periods when corporate profits are falling and unemployment rates are rising, since consumers need power in good times and bad.

Hydro One comes with a couple of additional benefits: Compared with its peers, it has a relatively low amount of variable debt, which insulates it to some extent from rising borrowing costs; and its credit rating is very high, even for a utility, adding to its safe profile.

But the share price is up more than 9 per cent over the past year, outperforming the S&P/TSX Composite Index and rich dividend plays such as Canada’s big banks, pipelines, telecoms and other utilities.

What stands out even more: Hydro One’s share price is up about 80 per cent over the past four years, even as the dividend has crept up by just 5 per cent each year over this period. That explains the declining yield.

“The yield is not at the point where you are going to hold it for the yield. Yet, I don’t think of it as a high-growth company either,” said Robert Gill, portfolio manager at Toronto-based Goodreid Investment Counsel.

As a regulated utility, growth tends to be slow and steady. In the three-month period ended Sept. 30, Hydro One reported that revenue increased 6.2 per cent from the same period in 2021, while net income increased 2.3 per cent.

“Right now, it’s between both” – the yield is not particularly enticing, yet growth is unspectacular – “and I’m not sure that’s the best place for it to be,” Mr. Gill added.

There are certainly plenty of other, more attractive dividend yields out there.

Within the Canadian utility sector, Fortis Inc. has a yield of 4.1 per cent and big growth plans. Among pipelines, TC Energy Corp. TRP-T has a yield of 6.5 per cent. Telecom giant BCE Inc. BCE-T has a yield of 6.3 per cent. And among Canada’s largest banks, Bank of Nova Scotia BNS-T leads the way with a yield of 5.6 per cent.

No doubt, Hydro One has outperformed all these alternative dividend plays over the past year in terms of stock performance. The question now is whether it can continue to deliver bigger gains.

A growing population and the trend toward electrification – particularly with the rising number of electric vehicles on the road – should help drive revenue growth over the long term. And a deteriorating economy will underscore near-term investor demand for havens such as utilities.

But Hydro One’s low dividend yield, and high stock price, appears to be reflecting an upbeat future for the utility already. That could limit future gains.

The low yield could even pose a risk if, say, a recession is avoided or it proves to be a brief one, pushing investors back into tech stocks or other areas of the market with more exciting growth potential, diminishing the need for safe stocks.

Hydro One’s share price has backed off from its recent high, suggesting that the 3-per-cent threshold for the dividend yield may be the lower limit for now. Wake me up when it approaches 4 per cent again.

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