Another Issue Confounding Utilities ETFs

It seems like only yesterday that utilities stocks and exchange-traded funds, such as the Utilities SPDR (ETF) XLU, were setting the market ablaze.

Sure, XLU, the largest utilities ETF by assets, is still up 14.5 percent year-to-date, good for one of the better performances among the sector SPDR lineup. However, XLU resides more than 7 percent below its record high set in July, and much of the ETF's losses have been accrued in recent weeks. Intensifying speculation that the Federal Reserve will raise interest rates in December is weighing on the rate-sensitive XLU and rival utilities ETFs.

A Defensive Favorite

By virtue of its bond-like characteristics but hearty yield, XLU is a favorite among defensive-minded, yield-starved income investors. Unfortunately, persistently high valuations are suppressing utilities sector, potentially making the sector even more unattractive as a rate hike looms.“Like most ETFs that invest in utilities companies, XLU has historically paid a healthy yield. However, income-hungry investors have driven valuations in the sector up to the point where it yielded a meager 3.4 percent as of the end of October 2016. This is well below the 4.0 percent average yield the fund has sported over the past few years,” said Morningstar in a recent note.

Utilities are also saddled with heavy debt burdens, which could eventually pinch payout sustainability. XLU has a debt-to-equity ratio of 1.3, according to AltaVista data.

Despite Above-Average Yields, Investors Shy Away

Data suggest investors are growing leery of utilities stocks even with the still above-average yields offered by the sector. Year-to-date, XLU has added over $1.1 billion in new assets, but the ETF bled $810.3 million in the third quarter. XLU has been unable to stop the bleeding in the fourth quarter, at least not in significant fashion, with inflows of less than $2 million.

More About The Fed

Much of the near-term outlook for XLU and friends revolves around the Federal Reserve.

“Long viewed as bond substitutes, utilities tend to generate stable cash flows and attractive yields. There is a long-standing relationship between interest rates and utilities' performance relative to the rest of the market. When rates rise or investors fear higher rates, utilities tend to underperform. During a low-rate environment or when rates are falling, utilities tend to outperform,” added Morningstar.

XLU, which debuted in 1998 and holds 30 stocks, tracks the Utilities Select Sector Index. That index has a price-to-earnings ratio of 20.58, a slight premium to the S&P 500.