You wouldn’t normally think of utility stocks as the sort of things that would thrive in times of rising interest rates. Indeed, so far this year, they have not thrived: the S&P/TSX Capped Utilities Index is down 11.6% for the year. However, there are those who argue that utility stocks are poised to thrive in the year ahead.
Noting the tendency of utility stocks to have stable earnings during recessions, they say utilities will perform better than other sectors if high rates cause a recession. While I don’t fully endorse this view myself, I can see some merit to it.
In this article, I will explore why some think that utility stocks might be Canadian investors’ best safeguard against rising rates.
Why utility stocks can thrive in times of rising rates
Generally speaking, the direct effect of higher rates — that is, higher interest expenses — is not good for utility stocks. Utilities are among the most indebted companies in the world. The reason for this is that their operations are very expensive to run. Utility companies have to manage vast assets such as hydroelectric dams, power stations and circuits. Not all utilities own the local power plant outright, but most are involved in the upkeep of such infrastructure in some way. This costs a lot of money. At the same time, utility stock investors generally expect their companies to pay dividends. This all adds up to a situation where utilities tend to have very leveraged balance sheets.
On the surface, then, rising rates are bad for utilities. If their debt is a variable rate, it will produce rising interest expenses immediately. If the debt is a fixed rate, then it will produce rising interest expenses when it has to be refinanced. This is a bad thing in itself. However, if interest rates rise so much that they cause a recession, utilities can fare better than other companies. Utilities provide essential services that people continue paying for even when laid off during recessions. The high rates typically seen immediately before recessions take a bite out of earnings, but since utilities have such stable revenue, they are more likely to survive recessions than other companies are.
A utility stock that has done comparatively well this year
Fortis (TSX:FTS) is one utility stock that has done relatively well this year. It is down only about 1% for the year, which is better than the average TSX utility. Factoring in the company’s 4.2% dividend yield, FTS’s total return for the year is positive.
Fortis has outperformed the TSX utilities sub-index by about 10% this year. The reason for its outperformance is that the company is financially sound. Many utilities pay out more in dividends than they are actually earning in profit. Fortis, with its 72% payout ratio, is more stable than such utilities.
Additionally, the company invests more heavily in growth than other utilities do. Currently, it is embarking on a capital expenditure program that it says will increase its rate base. If it all pays off, then Fortis’s revenue will be higher in the future than it is today. Historically, Fortis’s expansion projects have worked out. So, there is reason to be optimistic about FTS stock today.
Foolish takeaway
Rising rates aren’t good for utilities in themselves. However, when rising rates cause recessions, they sometimes cause utilities to perform better than other sectors, relatively speaking. This isn’t necessarily a reason to run out and invest all your money in utilities today. But it’s a point worth keeping in mind in the future.
