Utility stocks are definitely subject to interest rate risk and can be significantly impacted by changes in interest rates. Utility firms can be adversely affected by rising interest rates in two ways.
Competition With Bonds
First, an interest-rate increase makes bonds look more attractive to conservative investors – the very type who are typically drawn to the utilities sector stocks. For example, following the financial crisis of 2008 and the resulting sustained near-zero interest rate environment, utility companies benefited by drawing the attention of many conservative, income-focused investors; with bond yields at such very low levels, the average dividend yield of utility companies, which was around 4.8%, offered an attractive alternative. However, if interest rates and the corresponding yields available on debt instrument begin to rise, utilities will likely lose some investors to the bond market.
Interest Rates and Debt Levels
The second way interest rates impact utility companies is by increasing their borrowing costs. Of course, an interest-rate hike affects all businesses this way, but it’s an especially important factor for utility companies because of their typically high debt levels. Major utility firms have major capital expenditures and high debt-to-market cap levels. The construction of power plants and the maintenance of the vast infrastructure required to deliver gas, water, or electricity makes utilities a very expensive business that requires major debt financing.
Utilities have benefited from cheap financing rates in recent years, but a significant rise in interest rates would change that. Some utility companies can offset their increased borrowing costs by passing them on to customers, but being able to raise their rates enough to cover the extra cost of financing is not a given. If companies are unable to pass on the extra costs to their customers, these costs are at least partially borne by their equity investors and bondholders, thus making the companies less attractive to new investors.
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