If you're looking to make investment income through dividends, you may want to allocate a portion of your portfolio to utility stocks. These have long been seen as a conservative option; they can allow you to capture longer-term dividends than you can get in other areas of the market.
Utility stocks are similar to other stocks that are necessary. For instance, these may be the stocks of companies that make toothpaste and soap. Useful, everyday items such as those most often do not return large amounts of profit at first. But they can be part of a smart lower-risk portfolio.
You can invest in utility stocks through any broker. However, you should learn about them before doing so. That way, you can ensure that they meet your goals and tolerances.
- Investing in utilities can be a way for some people to have a low-risk investment that can generate income by paying dividends.
- Because utilities are essential, they tend to be stable investments. But certain events, such as a rise in interest rates, can cause these stocks to lose value.
- The low-risk nature of utility stocks also means that you won't often see large profits from your investments.
What Are the Benefits of Utility Stocks?
Utilities are companies that deliver essential services; for instance, these could be water, gas, and electricity. They are always in demand, no matter the economic circumstances. That means the sector tends to be one of the more stable areas of the stock market. This is true in terms of its day-to-day performance.
Utility stocks tend to hold up better in falling markets. That's because people are usually in less of a rush to sell their lower-risk investments when the broader environment turns sour.
Utility stocks are riskier than most asset classes within the bond market. But they are most often seen as being lower-risk than the overall stock market.
The primary benefit of utilities is that they often pay above-market dividends. Consider the exchange-traded fund (ETF) Select Sector SPDR-Utilities (ticker: XLU). It invests across the entire U.S. utility sector and it has an emphasis on the largest companies.
Over the past decade, XLU has typically offered a yield about 1.75 to 2.5 times that of the S&P 500 Index, which is a measure of broader U.S. market performance. It has done so with a lower level of volatility than the market as a whole.
How Does Capital Appreciation Work?
Here's the flip side: The potential for longer-term capital appreciation is limited with utilities. The growth opportunities for most companies in the sector are limited. This is reflected in their stock price performance. One benefit is that with fewer opportunities to invest for future growth, the companies have more cash on hand to pay out dividends.
But over time, above-average dividends can have a significant impact on total return. Consider the XLU mentioned above. From its debut on Dec. 22, 1998, through June 10, 2014, XLU produced a cumulative total return of 150.1%. It had an average annual total return of 6.1%.
In that same period, the SPDR S&P 500 ETF (ticker: SPY), which tracks the S&P 500 Index, had a cumulative total return of 112.8%. Its average annual total return was 5.0%. This isn't meant to show that utilities are a better investment. Rather, it shows that another few percentage points of dividend yield may add up over the long term.
What Are the Risks of Utility Stocks?
Just like the rest of the stock market, the utility segment is subject to broader market forces. During the most recent market declines of the past decade, utility stocks lost about half of their value on a price basis. This doesn't count dividends. Keep that in mind when deciding between investing in bonds or dividend-paying stocks such as utilities.
Other factors can also have a negative impact on the performance of utility stocks. Rising interest rates can cause the sector to underperform for two reasons:
- Higher rates increase utilities’ interest burden. That's because companies in the sector tend to be capital-intensive; therefore, they are 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.
- Duke's interest burdens would increase with the higher rates. From 2014 to 2018, both assets and liabilities significantly increased. This suggests that it used debt to finance assets. If so, rising interest rates will increase the debt that Duke maintains.
In most cases, stock prices drop when interest rates climb. This can also decrease equity funding for a utility company. Income-oriented investors may gravitate toward bonds and away from riskier yield options in the stock market. The utility sector is also heavily regulated. That makes it vulnerable to shifts in government policy.