Hard To Knock The Utilities Hustle

The Utilities SPDR (ETF) XLU fell almost 2.4 percent last week after Goldman Sachs downgraded the sector citing valuation concerns.

“With the utility sector index roughly 10% higher than YE 2016 levels and having outperformed the S& 500 by 1% (excluding dividends) and 2% (including dividends), we become bearish on valuation,” said Goldman Sachs analyst Michael Lapides in a note.

Goldman lowered its view on the utilities sector to Cautious from Neutral. Still, XLU, the largest utilities exchange traded fund by assets, is higher by about 7 percent year-to-date. That's an impressive performance when considering interest rates have been boosted twice by the Federal Reserve and no sector is as inversely correlated to rising Treasury yields as utilities. 

Hard To Knock The Utilities Hustle

XLU and rival utilities ETFs sport dividend yields north of 3 percent. That is well above what investors will find on 10-year Treasuries and the S&P 500, explaining why investors remain fans of the sector even in the face of rising interest rates. The rub is that to gain the advantage of the sector's high yield and defensive traits, investors typically pay up on valuation, so the utilities sector being pricey is nothing new.

Additionally, some data points suggest the sector isn't being pinched by rising interest rates in the fashion investors were expecting as the Fed set on its 2017 rate hike course.

“We've long told investors that a wide spread between utilities' dividend yields and interest rates would dampen the market's reaction to rising rates,” said Morningstar in a note. “This continues to play out. In June, the 10-year U.S. Treasury rate fell again to 2.2%, yet utilities' dividend yields have held near 3.5%, with dividend growth offsetting still-climbing stock prices. The 130-basis-point spread between Treasuries and dividend yields remains a bullish signal.” 

Impressive Performance

Through mid-June and prior to the Goldman downgrade of utilities, only the technology and healthcare sectors were outperforming utilities group on a year-to-date basis.

“The current spread between utilities' 3.5 percent average dividend yield and the 2.2 percent 10-year U.S. Treasury yield remains historically wide, suggesting utilities could still produce attractive returns even if the Federal Reserve continues to raise rates,” said Morningstar. “Attractive dividend growth is a key component.”

Goldman's downgrade did chase investors from XLU. For the week ended June 29, XLU bled over $704 million, a total surpassed by just three other ETFs over that period.