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Utilities Shaking the Interest-Rate Stigma

Strong fundamentals should allow the sector to continue producing positive returns even as interest rates climb.

Most investors wouldn’t expect gains from their defensive, income-oriented holdings as interest rates shoot up. But that’s exactly what utilities have offered investors. Even though utilities have trailed the market, the sector is up 7.6% since last August even as 10-year U.S. Treasury rates have tripled.

Utilities have been worst-performing sector since the market bottom - source: Morningstar

We think there are two reasons utilities might be able to hold onto these positive returns even if interest rates continue to climb. First, utilities’ dividend yields continue to offer historically attractive premiums to interest rates. During the most recent cycle, most utilities’ dividend yields have been nearly triple the 10-year U.S. Treasury yield, the highest premium in at least 30 years.

List of undervalued utilities growing as sector underperforms - source: Morningstar

Another reason we think utilities can continue producing positive returns even as interest rates climb is their strong fundamentals. Most utilities have secure balance sheets, comfortable dividend payout ratios, and plenty of growth opportunities. We estimate 5% average annual earnings growth for U.S. utilities during the next three years. This growth plus the sector’s 3.4% dividend yield suggests solid returns ahead for the ultra-defensive sector. Inflation is one of the few headwinds we’re watching.

Utilities’ dividend yields still attractive even after jump in rates - source: Morningstar

The key growth drivers for the sector remain renewable energy and network upgrades. The Texas winter storm blackouts in February showed the challenges utilities face as renewable energy investment grows faster than the current electric grid can handle. Relying on intermittent wind generation and a single backup generation source—natural gas—failed in Texas. This has created urgent policymaking discussions nationwide about prioritizing grid upgrades alongside renewable energy to ensure reliability during extreme weather.

More than half of new U.S. wind, solar capacity going to Texas - source: Morningstar

With utilities valuations back to reasonable levels, we think investors should look for those that can benefit both from renewable energy growth and network investment. Standouts include American Electric Power, which has ample growth opportunities as the owner of the largest electric network in the U.S.; NiSource, which is growing its renewable energy portfolio in Indiana while investing in gas distribution upgrades throughout its system; and Edison International, which plans $5 billion of annual investment in Southern California’s electric grid to meet the state’s energy policy goals. All have dividend yields above the sector average.

Top Picks

FirstEnergy FE Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $42 Fair Value Uncertainty: Low

FirstEnergy's shares fell 30% in July and have not recovered following the arrest of the Ohio House Speaker and four others on racketeering charges. Although no FirstEnergy executives have been charged and FirstEnergy no longer owns the entity that benefited from the alleged bribery, we expect it will have to repair regulatory and political relationships in Ohio, which represents less than 20% of earnings. FirstEnergy's underlying businesses are solid. As the bribery headlines and COVID-19 issues fade, we estimate 5% annual EPS and dividend growth driven by strong FERC-regulated transmission investment.

Edison International EIX Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $70 Fair Value Uncertainty: Medium

With the stock trading at a discount to its peers and a 4% yield, Edison offers a triple play of value, growth, and income. Despite California’s ever-present political risk, the state’s progressive energy policies offer more growth opportunities for utilities than most other states. Edison has stakeholder support to harden the grid against natural disasters, integrate renewable energy, and support electric vehicle adoption. Edison’s electric-only business, recent regulatory success, and $5 billion annual investment plan give us confidence that it can average 6% earnings growth during the next five years. Management recently raised the dividend 4%, and we expect that pace to pick up.

American Electric Power AEP Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $89 Fair Value Uncertainty: Low

Across much of AEP's vast service territory, states were slower than others to adopt renewable energy standards, resulting in slower growth in this field for AEP. But state regulators overseeing AEP’s service territories are now embracing renewable energy development, providing significant growth opportunities beyond our five-year forecast. AEP will also benefit from investment opportunities in its transmission and distribution network, which is the largest in the U.S., as other utilities also connect renewable energy projects.

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