When Federal Reserve Chairman Ben Bernanke announced on Sept. 13 that low interest rates will prevail well into the future, every utility stock shareholder should have cheered with approval --and the roar of buy orders being placed should have been deafening.
Utility company shares have long had a reputation as "widow and orphan stocks." Considered to be boring with a predictable dividend income flow, they're often perceived to be best suited for only the most risk-averse of investors.
But the response of Bernanke and other central bankers to the global recession has altered this attitude in the favor of Foolish Investors. To revitalize the housing sector and financial markets, central banks around the world have spent trillions buying and swapping government bonds to keep interest rates low. As interest rates fall, utility stocks are rising, as yield-seeking investors seek alternatives to Treasury bonds and certificates of deposit, which are offering anemic returns.
Utility dividends are higher
At present, the dividend yield for the utility industry is 3.80%. For a member of the Standard & Poor's 500 Index, it's around 2%. A 10-year Treasury bond now provides a return of about 1.75%.
Duke Energy (NYSE: DUK)
Southern Company (NYSE: SO)
Exelon Corp (NYSE: EXC)
SPDR Utilities Exchange Traded Fund (NYSE: XLU)
10-Year Treasury Bond
5-year Dividend Growth Rate
Source: Motley Fool CAPS.
Utility stocks also rise in a falling interest environment because of the sound customer base. Low interest rates generally indicate a weak economy as central bankers inject funds into the financial markets to reduce interest rates after a downturn to encourage consumers to buy houses, and to motivate banks to lend more money to businesses to expand operations and hire more workers. Utility stocks become more attractive as stable investments with a strong yield, as there will always be a demand for the electricity provided, no matter how dire the economy. There's also help from above: Regulators always ensure a healthy return for power companies, as they're needed to provide electricity to the factories, farms, and other crucial parts of an economy.
Falling interest rates mean cheaper cost of capital
Low interest rates also improve both the income statement and balance sheet of utility companies. When interest rates fall, utility companies can borrow cheaply and heavily because of the stable earnings, allowing for debt to be responsibility accumulated for needed capital expenditures. The lower interest rates reduce the credit costs for the company.
Stronger U.S. dollar means lower interest rates and fuel prices
Another factor making utility stocks more attractive is that central bankers around the world are initiating quantitative easing measures. Currencies then fall in value from basic supply-and-demand fundamentals: More paper money is being printed without the corresponding economic growth, making the U.S. dollar much more attractive as a "safe haven" asset. That helps keep interest rates low in the United States as foreign buyers purchase Treasury bonds because of the security, liquidity, and depth of the American government debt market.
What also happens from a stronger U.S. dollar is that commodity prices for oil, natural gas, and coal fall. If investors are worried about the future of the global economy, funds will plowed into U.S. dollar instruments, not oil, natural gas, or coal assets. That makes the price of fuel for utilities that much cheaper.
As a result of these Bernanke-led measures, utility companies are now benefiting from both low interest rates and cheaper fuel supplies. This is as good as it gets for investors, as the total returns of these stocks increase from companies borrowing at a cheaper price and buying less expensive fuels. The robust dividend yield makes a utility a much better income instrument than a Treasury bond. Utilities have better earnings when borrowing costs are lower and fuel prices are falling. As a result, the SPDR Utilities exchange-traded fund is trading close to its 52-week high.
Not gonna end anytime soon
This economic model should continue well into the future. Global central bankers, with Bernanke at the helm, have pledged to keep interest rates low for the long term. Fuel prices are falling because of an anemic recovery in the United States, slumping economic growth in China and India, and Europe's slide back into a recession. All of these factors combine to make utility stocks very appealing for both the near term and the long term, as the superior income and capital gains of these stocks power a higher total return.
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The article Listen to Ben Bernanke and Buy Utility Stocks originally appeared on Fool.com.
Jonathan Yates and The Motley Fool have no positions in the stocks mentioned above. Motley Fool newsletter services recommend Exelon and Southern. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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