Introduction

Utility stocks are experiencing a significant downturn as interest rates reach their highest levels in over a decade. Technical indicators suggest that this decline is historic in nature, with widespread selling leading to a sharp decline in the sector. This is surprising, as utility stocks are typically considered defensive investments. In this article, we will explore the reasons behind this decline and its potential implications for investors.

Reasons for the Decline

The slide in utility stocks is closely tied to the recent spike in Treasury yields, which indicates a “higher-for-longer” rate environment. Unlike previous periods of decline, which occurred around Federal Reserve rate cuts and were followed by positive returns, this decline is driven by rising interest rates. Experts suggest that the current interest rate regime is the main cause of this sell-off. However, there is a historical tendency for utility stocks to rally after extreme declines, which may provide some hope for future recovery.

Impact of Rising Interest Rates

Rising interest rates have a double impact on utility stocks. Firstly, their high-yield, low-growth nature leads many investors to treat them as bond proxies. However, with Treasury yields now above 5%, the dividend income from utilities appears less attractive. Secondly, utility companies often carry significant debt, which means they face higher interest expenses when refinancing or expanding. This increased financial burden contributes to the decline in utility stocks.

The Case of NextEra Energy

One of the hardest-hit companies in the utility sector is NextEra Energy, the largest holding in the Utilities Select Sector SPDR Fund (XLU). The stock has experienced a 23% drop since September 22nd. NextEra’s sister company, NextEra Partners, recently announced a distribution growth rate cut, further contributing to the decline in NextEra Energy stock. These developments have prompted some investors, such as Ritholtz Wealth Management CEO Josh Brown, to sell their positions in NextEra Energy.

Analyst Outlook

Despite the significant decline in utility stocks, some Wall Street analysts predict more downside. According to UBS analyst Ross Fowler, utilities are currently overvalued by approximately 9% based on their valuation regression model, which considers interest rates and growth among other factors. Sentiment remains bearish for utilities as long as interest rates continue to rise, potentially discounting the long-term bullish fundamentals associated with the clean energy transition.

It is important for investors to closely monitor the impact of interest rates on utility stocks and consider the potential risks and opportunities associated with this sector.

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