Those who are looking for ways to generate investment income through dividends often allocate a portion of their portfolios to utility stocks. Utilities have long been viewed as a conservative option that enables investors to capture longer-term dividends than are available in other areas of the stock market.
Utility stocks are similar to other stocks that are historically necessary, such as toothpaste and soap. Useful, everyday items such as these generally do not return large amounts of profit to investors initially but are part of an investor's lower-risk portfolio.
You can invest in utility stocks through any broker; however, you should learn about them before doing so to ensure they meet your investing goals and tolerances.
Benefits of Utility Stocks
Utilities are companies that deliver essential services such as water, gas, and electricity. Since these services are always in demand regardless of economic circumstances, the sector tends to be one of the more stable areas of the stock market in terms of its day-to-day performance.
Utility stocks also tend to hold up better in falling markets, since investors are usually in less of a rush to sell their lower-risk investments when the broader environment turns sour. While utility stocks are riskier than most asset classes within the bond market, they are generally seen as being lower risk compared to the overall stock market.
The primary benefit of utilities is that they typically pay above-market dividends. In the past decade, the exchange-traded fund (EFT) Select Sector SPDR-Utilities (ticker: XLU), which invests across the entire U.S. utility sector—with an emphasis on the largest companies—has typically offered a yield about 1.75 to 2.5 times that of the S&P 500 Index—a measure of broader U.S. market performance. Notably, it has done so with a lower level of volatility than the market as a whole.
The flip side is that the potential for longer-term capital appreciation is limited with utilities. The growth opportunities for most companies in the sector are limited, and this is reflected in their stock price performance. One benefit of this is that with fewer opportunities to invest for future growth, the companies have more cash on hand to pay out dividends.
Over time, however, above-average dividends can have a significant impact on total return. Consider the utilities ETF (XLU) mentioned above. From its debut on Dec. 22, 1998, through June 10, 2014, XLU produced a cumulative total return of 150.1% and an average annual total return of 6.1%.
In that same period, the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index had a cumulative total return of 112.8% and an average annual total return of 5.0%. This isn't meant to illustrate that utilities are a superior investment, but rather to show that an extra few percentage points of dividend yield may have the potential to add up over the long term.
Utility Stocks Risk
Similar to the rest of the stock market, the utility segment is subject to broader market forces. During both of the major market declines of the past decade, utility stocks lost about half of their value on a price basis (not counting dividends). Income investors need to keep this in mind when deciding between investing in bonds or dividend-paying stocks such as utilities.
Two other factors can have a negative impact on the performance of utility stocks. First, rising interest rates can cause the sector to underperform for two reasons:
First, higher rates increase utilities’ interest burden because companies in the sector tend to be capital-intensive and therefore more heavily indebted. For instance, Duke Energy had a 2018 total debt to total asset ratio of 0.71. This means that 71% of its assets were funded by debt.
In this case, Duke's interest burdens would increase with the higher rates. From 2014 to 2018, both assets and liabilities significantly increased, suggesting that it uses debt to finance assets. If this is the case, rising interest rates will increase the debt Duke maintains.
Generally, stock prices drop when interest rates climb, which can also decrease equity funding for a utility company. This causes income-oriented investors to gravitate toward bonds and away from riskier yield options in the stock market. In addition, the utility sector is heavily regulated and therefore vulnerable to shifts in government policy.