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By Josh Peters, CFA | 02-09-2011 04:53 PM

Two Utility Stocks for a Rising Rate Environment

A growth element is important to help protect you against rising interest rates, says senior analyst Travis Miller.

Josh Peters: Hello, this is Josh Peters. I'm the editor of Morningstar DividendInvestor newsletter.

If you are interested in dividends, chances are you take a look at utility stocks now and again. They've played a big role in producing a lot of income for a lot of retirees and a lot of reinvested dividends for younger savers for many, many decades.

But with interest rates rising, what might that be doing to the utility story? Is this still a good time to buy? Or is it time to sell? Time to hold?

To answer some of these questions, I have brought in Morningstar's senior utility analyst, Travis Miller.

Travis, thanks for joining us today.

Travis Miller: Sure. Thanks.

Peters: So, we've had a pretty big move in interest rates, especially at the long end of the curve. The 10-year Treasury, I think the last time we sat down to talk about utilities was maybe 2.5%, 2.75%. Now we are looking at 3.y5%, a full percentage point move or more.

How much has that really changed the value equation, the value proposition for utility stocks?

Miller: It certainly hurt them relative to the rest of the market. We saw relative outperformance for those higher-yielding names over the first three quarters of 2010, but in the fourth quarter when the rest of the smaller-cap, mid-cap stocks took off in other, high-growth industries, utilities severely lagged the market, and especially those high flyers.

So, now we've seen about flat returns for a good six months or so in this space with the higher-yielding names, and we still think the sector is about 10% overvalued.

Peters: Is there anything that people should maybe be worried about in terms of either valuation--I don't know if 10% perhaps is the kind of level where you get nervous on that alone--or could it be that inflation perhaps being the culprit behind rising interest rates or even just rising interest rates themselves are actually hurting the fundamentals of these utilities' performance?

Miller: Certainly, utilities are highly levered. So, any kind of move up in interest rates is going to hurt the bottom line for them. It's going to raise interest cost. It also makes the dividend yield look less attractive for equity investors.

So, with 4.5% dividend yield on average across that regulated utility space, we still think there are some attractive total returns for investors who might be scared of downside risk, but again rising interest rates always hurt the most regulated utilities.

Peters: So, it sounds like stocks aren't "run for the hills" overvalued by that, perhaps maybe picking individual stocks and trying to maximize value with research is perhaps really important in the sector right now?

Miller: Absolutely. We think that investors need to look for two things right now in utility stocks. One, are they in good regulatory environments where they can adjust very quickly to rising interest rates and additional cash costs. And two, is there growth opportunity? So we need to see growth opportunity from infrastructure investments, particularly in the wires and distribution businesses where you have slight demand growth but also needs to connect environmentally friendly generation and to support the system in general, which is becoming quickly depreciated.

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