Global Utility White Paper CONFIDENTIAL
6. Interest Rate Risk —-A Common Misperception
We find a common misperception among investors to be the degree of interest rate risk in the global utility sector, as interest rate sensitivity has declined steadily since the modern utility industry came into being in the early 1990s.
There is a relatively higher degree of interest rate risk in the defensive, fully-regulated utilities given their bond-like returns and the capital-intensive nature of the industry, which demands heavy use of debt financing. Such defensive fully-regulated utilities can be found in all regions, however the highest concentration is found in the US. European, Asian and Latam utilities are more levered to economic growth and therefore tend to be no more interest rate-sensitive than broad market equities.
Even the performance of the more interest rate-sensitive US utilities is not fully determined by interest rates. For example, during the market rally from fall 2002 to summer 2007, the US utility sector generated a non- beta-adjusted annualized total return 5.2% higher (2.8% from better price appreciation and 2.4% from dividend reinvestment) than the S&P 500, while the 10-year Treasury yield rose from 3.6% to 4.9% (+130 bps) over this period. Valuation re-rating and earnings growth from generators, as economic growth tightened power markets and raised commodity prices, outweighed the negative impact of rising interest rates.
We would note furthermore that yield relationships have moved to unprecedented extremes such that, for example, the dividend yield for US regulated utilities versus the 10-year Treasury yield currently sits at 7 standard deviations above the mean from the historical pre-2008 environment (see graph below). An even more dramatic relationship exists for the European utilities. This suggests that policy rates are at such levels that there is substantial cushion against rising rates.
US utilities/US 10-yr Treasury Ratio
BBUTY fedex. / USGGIOVE Index 2.3012. «28
Finally, we track interest rate risk in the Electron risk model for all positions. We are not looking to make macro calls, and the portfolio’s net interest rate risk is kept within acceptable limits as we select stocks in the global utility sector. This process has worked well for us as over 7 years we have posted strong returns and alpha generation in both rising and falling interest rate environments. As a result, many investors are pleasantly surprised to learn that despite perceptions of the global utility sector’s interest rate sensitivity, Electron’s return correlation to interest rates is slightly lower than the HFRI Equity Hedge Index’s return correlation to interest rates.
19 Electron Capital Partners, LLC
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