Utility Stocks: Why No New All-Time High?

The Fed cut interest rates last month but the Dow Jones Utility Average has barely budged since.

No one can say the Federal Reserve hasn’t held up its end: A 50 basis point cut in the benchmark Fed Funds rate, with a promise from Chairman Jerome Powell of much more to come.

But since the central bank made its move September 18, the Dow Jones Utility Average is hardly in the black. And so for that matter is the iShares Select Dividend ETF, often referred to as the “DVY” and a benchmark for equity income portfolio strategies. Real estate investment trust ETFs are actually in the red.

Some might wonder if there’s something deeply wrong with dividend paying stocks that interest rate cuts can’t cure. Have dividends indeed lost their appeal entirely in an era of 5 percent cash returns? Is a wave of dividend cuts on the way as the economy weakens, or alternatively as companies instead deploy spare cash to ever-popular stock buybacks? 

Invest long enough and you’ll learn just about anything is possible when it comes to the market. But I have three observations for any income seekers tempted to throw in the towel on dividend stocks.

First, while the DJUA has failed to make a new all-time high this year, a growing number of utility stocks are. Southern Company (NYSE: SO), for example, has broken 90 this month after failing to break 80 in its century plus history.

Index averages and related ETFs are an easy way to invest. But they all have a fatal flaw: The more assets they attract, the more they have to invest in the biggest capitalization stocks.

That’s sometimes good for returns: The biggest capitalization utility NextEra Energy (NYSE: NEE) returned 41.8 percent in the first nine months of 2024. But sometimes it’s not, as the same stock dropped -25 percent in 2023.

Held in a balanced portfolio of individual stocks, NextEra’s ups and downs had moderate impact on overall returns. But in a capitalization weighted ETF, investors got a serious gut check last year. Lesson: Don’t judge a sector just by looking at an index ETF.

Second, consider that talk about rate cuts started in mid-April, when inflation data began to moderate. And it intensified over the summer as employment data softened, inflation metrics declined further and various Fed officials began to hint very broadly that cuts not increases were ahead.

Investors had a lot of notice that rate cuts were coming. So by September 18, when the Fed actually pivoted away from two-and-a-half years of “higher for longer,” the DJUA was already up almost 30 percent. The DVY was ahead 17 percent. And the S&P Real Estate Index had advanced better than 25 percent.

Those gains incidentally left the S&P 500’s 12 percent return relatively in the dust. And they were even further ahead of the Nasdaq 100’s gain of less than 10 percent.

Bottom line: Dividend stocks were already pricing in at least the Federal Reserve’s initial shift.

Third and most important, the benefits of declining interest rates will be realized progressively for capital-intensive businesses like REITs and utilities, not all at once.

Starting in second half 2022, companies endured quarter after quarter of rising interest expense, as higher borrowing costs raised both the cost of asset expansion and refinancing maturing debt.

Stronger companies were able to offset the negative impact on the bottom line by growing revenue and cutting expenses elsewhere. Some sold assets to fund capital spending or merged to form stronger companies. Utilities like NextEra Energy made creative use of tax credits from the Inflation Reduction Act to raise cash. And regulators in some states—notably California—boosted utilities’ allowed return on equity to keep pace with rising rates.

But even the most successful companies were constantly challenged by the Fed’s policy of “higher for longer” interest rates. And while utilities I’ve favored have managed to stick with the investment plans behind their earnings and dividend growth guidance, it’s fair to say I’ve been prepared for disappointment every time they’ve updated guidance.

Borrowing costs for investment grade utility companies have come down considerably since mid-April. BBB-rated Edison International’s (NYSE: EIX) 3.45 percent First Lien Secured Bonds of February 1, 2052, for example, were priced to yield as much as 6.64 percent a year ago. That’s now down to less than 5.2 percent.

On the other hand, these bonds’ yield to maturity is still 170 basis points higher than it was in February 2022, when the utility issued them at the start of the Fed’s interest rate raising cycle.

The inflection point in this interest rate cycle has passed. But it will be some time if ever before borrowing costs retreat to the levels of a couple years ago.

That means companies with major near-term refinancing will have to swap cheaper for more expensive debt. Projects will continue to cost meaningfully more to finance than earlier in the decade. And while interest expense increases will continue to moderate as they have, they won’t decline meaningfully except for companies that substantially cut debt.

The gradual pace of the cycle will benefit large and powerful companies that already have access to capital on favorable terms. Falling rates over the next couple years, for example, could dramatically cut Verizon Communications’ (NYSE: VZ) cost of refinancing the junk-rated debt of Frontier Communications (NSDQ: FYBR), when its planned acquisition closes in early 2026.

Lower interest rates are no panacea for the weak. Cheaper money may induce takeover bids. But to survive, management will have to continue taking aggressive action to cut debt. And while odds of success are good for regulated utilities, other sectors especially commercial real estate will remain under strain.

Bottom line: The Fed’s push to lower interest rates will be a major plus for dividend stocks over time. But only strong companies will be around to get the full benefit. Wise stock selection is still everything.