What Rising Interest Rates May Mean for Utilities Stocks

The following is an excerpt from the video series Dividend-Stock Deep Dive, hosted by Morningstar DividendInvestor editor David Harrell. Watch the full interview.

Harrell: You mentioned interest rates earlier. So, I think it was on March 16 that the Fed announced a 25-basis-point increase in the federal-funds rate. I think that was the first rate increase we've seen in three years, but we also expect multiple rate increases throughout 2022. Now, in your report, you spoke about several things, one that higher interest rates can be a drag on utilities' earnings because it increases their borrowing costs, higher interest rates can also make the dividends--the yield of the utilities--less attractive to income-focused investors. On the flip side, if these rate increases have their intended effect and actually tame inflation, that's a positive for utilities. How do you see things shaking out over the next year with these increasing interest rates and the utilities sector?

Miller: It's an interesting, again, like I said, confluence of events here, right? Just taken separately, inflation would be bad; taken separately, higher interest rates would be bad; taken separately, higher energy costs would be bad, right? So, all of these things when you come together, again, what does it mean for utilities? The worst of them is inflation. So, if you're going to rank what's the worst thing that could happen to utilities--it's inflation.

Interest rates is an interesting dynamic because we've been for the last two decades in such a low interest-rate environment, we really don't know what happens to utilities when you have interest rates that are in the 3%, 4%, in terms of the 10-year Treasury, 4% or 5% range. We just haven't seen that for 20-plus years. We think that's less of a threat--higher interest rates. We're at such low interest-rate levels right now, if you look over that last 20 years, we actually had utilities increasing substantially the amount of debt on their balance sheet and capital investment, and you've had interest costs on their income statements going down. Investing more and your costs are going down in terms of interest. Utilities are the second-largest borrowers of publicly traded debt behind banks. Anything, any incremental increase in interest rates will hit the bottom line. What you were saying earlier: Inflation is the number-one enemy.

If, as the Fed has suggested, rising interest rates can solve the inflation problem and bring that down to 2% or 3%, then you have a net benefit for utilities. But certainly, there's no good situation where you have rising interest rates, inflation, and higher energy costs...

Harrell: All three.

Miller: ...for utilities.