After raising the policy interest rate to 5% in July 2023 and keeping it flat for some time, the Bank of Canada finally cut it by 0.25%. How does this cut affect utilities that typically have large debt levels on their balance sheet?
There won’t be an immediate effect. But if further cuts occur – say, if the Bank of Canada brings the current 4.75% policy interest rate to 4% over time – eventually, it will lead to lower interest costs for new and refinanced debt. Thus, utilities will face meaningfully lower interest expenses.
The impact depends on the amount of the interest cut and how quickly it occurs. Generally, interest rate cuts should lower the cost of capital for utilities, which finance a good portion of their assets with debt. So, undervalued and reasonably valued utility stocks are good considerations for a scenario with further interest rate cuts as they could benefit from a healthy rise in their share prices.
Here are some of the utility stocks that have large debt levels on their balance sheet and could benefit from interest rate cuts. I’m going to compare the debt levels and interest expense of these utilities from several years ago.
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Fortis stock
Fortis’s (TSX:FTS) debt-to-asset and debt-to-equity ratios are 64% and 2 times, respectively, versus 63% and 1.9 times in 2020. While its debt ratios didn’t change much, its interest expense has gone up meaningfully. Its annualized interest expense is approximately $1.3 billion, which is roughly 29% higher than in 2020.
In 2020, the stock mostly stayed around the range of $52.50 per share, offering a dividend yield of north of 3.7% at the time. Interest rates rapidly increased in 2022, preventing the shares from going higher.
That said, the blue chip stock continues to deliver resilient results and increase its dividend sustainably. At $53.25 per share at writing, Fortis stock offers a decent dividend yield of 4.4%. And its next dividend hike is coming up in September! If interest rates fall meaningfully, the stock could return to the $60 level over the next few years.
Brookfield Infrastructure Partners
Brookfield Infrastructure Partners L.P. (TSX:BIP.UN) is another utility stock with large debt levels. Its debt-to-asset ratio is 68% versus 65% in 2020. Its trailing-12-month interest expense was almost US$2.5 billion compared to north of US$1 billion in 2020. However, in this period, it has also expanded its portfolio substantially with assets growing to US$103 billion from US$61 billion.
Brookfield Infrastructure is a more complex business with global operations and a diversified portfolio across regulated utility, transport, midstream, and data infrastructure assets. So, it also has debt in different currencies.
In 2020, the stock mostly stayed around the range of $38.40 per share, which resulted in a yield of about 4.2% at the time. The shares have been in a downtrend since 2022. At the recent price, analysts believe the stock trades at a steep discount of about 31%.
Today, the utility stock offers a cash distribution yield of close to 6%, which is attractive, particularly when you account for cash distribution hikes. The stock has increased its cash distribution for about 16 years. Going forward, it can healthily increase its distribution by 5 to 9% per year.
If you’re having trouble deciding on which utility stocks to invest in, you can gain broad exposure to the Canadian utility sector by considering iShares S&P/TSX Capped Utilities Index ETF, whose largest exposure is these two utility stocks making up about 22% and 15%, respectively, of the exchange traded fund.
