With the recent jump in interest rates, income investors and, in particular, bond owners, find themselves in a conundrum: How to generate current income from their investments without suffering the potential downside in the value of those investments, as rates continue to rise. Utilities may offer the best option for these investors, with dividends paying 3 percent or better, in comparison to the 10-year treasury rate of 2.6 percent at present.
Interest rates made a sudden, if not predictable, jump from their May lows, once investors began to worry that the Federal Reserve would begin to taper off its bond-buying program sooner rather than later. More than $80 billion poured out of bond funds and ETFs in June, including $14.5 billion from PIMCO alone, the largest bond-management firm in the business.
Bond investors are clearly rattled, with serious concerns about the potential for sizable losses as prices fall with continued selling, pushing rates higher. Keep in mind that rates leaped to a recent high of 2.75 percent from 1.6 percent, or by 72 percent, while the Fed was still purchasing $85 billion worth of bonds each month. Clearly, selling was enough to offset the Fed’s bond buying and still drive prices down significantly, causing the rise in rates that we have witnessed.
Fear over the Fed’s potential tapering also caused a significant selloff in stocks, with the Standard & Poor’s 500 falling 7.5 percent from its May 22 high of 1,687. During this correction in stocks, utilities fell by about 13 percent — nearly twice the overall market decline. Utilities had rallied by 22 percent from their November 2012 low, before stocks mounted their sustained rally through the May high. With this correction, utilities have become more attractively priced, and now represent an interesting alternative to bonds.
The American Taxpayer Relief Act of 2012 (H.R. 8) was passed by Congress and signed into law by President Barack Obama in the first days of 2013. This legislation extended the 0 percent and 15 percent capital gains and dividends tax rates for taxpayers whose income does not exceed the thresholds set for the highest income tax rate (39.6 percent). Those who exceed those thresholds ($400,000 for single filers; $425,000 for heads of households; $450,000 for joint filers) became subject to a 20 percent rate for capital gains and dividends.
Dividends paid by utilities in most cases are “qualified,” meaning that as long as the investor owns the shares of the utility for 61 of the 120 days surrounding the ex-dividend date, the dividend payment will qualify for the advantaged tax rate rather than the investor’s ordinary tax rate (investors should always consult with their tax adviser before making any tax-related investment decisions).
The potential for superior after-tax yields from utilities in comparison to after-tax taxable bond yields, especially in the context of rising interest rates, may offer investors a better current income alternative. While it is certainly possible that utility stocks may also decline in price if interest rates rise, a slow pace of that rate increase would likely have less of an impact on utilities than on bonds. In fact, if utilities were purchased after a further correction in stocks overall, investors would likely have not only an even higher dividend rate than is available at present, but would also have less risk of adverse price reactions to rising rates in comparison to owning bonds, especially longer maturity bonds.
If stocks experience a correction, and within that correction utilities correct by 10 percent, dividend yields on utilities should increase by about 10 percent. In this scenario, not only would investors buying utilities after a correction gain even higher yields in comparison to current bond yields, but would also own their utilities at lower prices (10 percent lower on average) so that downside risk is reduced and upside potential from price increases is enhanced. The purchase of utilities at the lower price-point and the associated higher dividend yield would serve as a cushion, protecting the investor to an extent from at least some of the possible adverse reaction to rising interest rates.
While utilities may not be the best solution for every income investor, for many they may offer the best alternative to expensively priced bonds that will certainly suffer should interest rates continue to rise — an outcome that is all but guaranteed once the Fed begins to taper off its bond-buying program sometime later this year.