High Rates Mean Better Valuations for Dividend Stocks

In their search for yield, investors have bid up dividend stocks to unprecedented levels. For example, in January the US utility sector was trading at a 5 percent premium to the broader market. Prior to 2009, utility companies typically traded at a 25 percent discount. That discount reflected the regulated, slower growth characteristics of the industry. The newfound premium (since reduced), on the other hand, is the result of investors seeking investments that can offer lower volatility and higher yield. In an environment of low rates, that yield becomes even more valuable. However, as rates begin to normalize, valuations on utility stocks, as well as other dividend-paying sectors, are likely to come down—a process already well underway. This should create a better entry point and value proposition for long-term investors.

This quest for yield led to lofty valuations in the utility sector. It traded at a premium of ~5% in January. However, the prospects of higher interest rates led to a correction in utilities. The Utilities Select Sector SPDR ETF (XLU) has fallen by 11.4% YTD (year-to-date). Meanwhile, the S&P 500 has returned ~2.5% YTD. This has restored some value in the utilities sector. Higher interest rates pose a challenge to the sector. Since the utility sector requires a lot of capital, these companies require a lot of capital and usually have a lot of debt. Higher interest rates mean that these companies have to spend more to service debt. This squeezes their margins.

Source: Market Realist

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