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Dividend Paying Utilities Stocks May Be A Bargain

So much of today’s investment cycle is driven by the Fed and its decision on whether or not to raise rates. The simple act of increasing by 0.25% is throwing dividend investors for a loop. On one hand, the bump in rates isn’t enough to make a CD or savings account worthwhile from an income point of view. On the other hand, the markets are selling down anything with a yield, including some traditional income sectors. For those investors who can see beyond the interest rate hype, there could be bargains in all that selling.

Case in point: utility stocks.

After plunging this year on the threat of a rate hike, the sector could be full of bargain stocks—many of which will do just fine over the longer haul if the Fed begins to tighten.

A Wall of Worry

Investors in high yielding dividend stocks and sectors have been climbing a wall of worry when it comes to interest rates. The perception is that when the Fed finally does raise rates, investors will flee for the exits and park their money in now-higher yielding treasuries. There’s no doubt securities like mortgage REITs are going to get killed—but this fear is evident in even some traditional, boring income sectors. Utilities in the S&P 500, as represented by the Utilities Select Sector SPDR ETF (XLU ), are down about 10.5% year to date.

The basic idea is that now that investors can get a “safer” higher yield somewhere else, utilities stocks will fall as investors sell them to move their money. However, this idea may be pure fantasy.

Despite the rosy outlook from the Fed, most analysts are only looking at a slight rise in interest rates. The Fed isn’t going to go from 0 to 15% overnight. In fact, many analysts actually predict that it will take over 18 months to even get to 75 basis points out of the Fed. That sort of rise doesn’t exactly turn a CD or money market fund into a great fixed-income product again—especially, when you consider some of the positives that utilities have. One of the biggest could be growth.

Many utilities have actually begun to transform themselves into engines of growth. Renewable energy capacity, as well as grid upgrades, help many utilities to move past their previous “window and orphan” monikers and give old, stodgy power producers a new image. What’s more is that many utilities going this route have placed these renewable assets in so-called YieldCos to gain additional dividends and efficiencies—such as utility NRG (NRG ) did with NRG Yield (NYLD).

However, it’s not just power producers that are realizing growth. Natural gas utilities are expanding their midstream assets and “dropping-down” these expanded pipeline networks into master limited partnerships (MLPs), while even uber-boring water utilities are finding ways to grow. Aqua America (WTR ) recently built a new water pipeline to supply fracking fields in the Marcellus shale.

Secondly, many of these growth elements have been funded by long term bonds scored at low interest rates. Utility stocks – thanks to their larger CAPEX requirements – have been prime beneficiaries from the Fed’s low interest rate policies.

Faster Growing Dividends

All of this growth potential equates to one thing: faster growing cash flows and dividends. Many of these businesses lie outside the realm of regulation and capped rates. The average utility now has vastly different product mix than before. This helps many utilities increase their dividends at faster rates than the rate of inflation—which is what the Fed uses to raise interest rates. That should keep utilities humming over the long term.

Making A Utility-Sized Play

Given the market’s potential overreaction, investors still looking for income may not want to overlook or abandon utilities. And given the market’s freak-out already, much of the damage may already be baked into shares.

You can certainly add a broad ETF like the previously mentioned XLU or iShares U.S. Utilities ETF (IDU ) to gain exposure to the sector. Perhaps better from a dividend investor point of view would be to look for utilities finding growth outside of the boring world of producing power and transmitting natural gas. Utilities like NextEra (NEE ) and its focus on renewables and co-generation capacity or Dominion (D) and its expansion into LNG exporting are some examples—both have high yields and have been driving those yields higher on the backs of these non-traditional businesses.

The bottom line is that there are many high-yielding sectors that have been hit hard by the Fed’s interest rate threats. And in the near to medium term, the threat is just that. Utilities will be just fine. The time to snag good yields is now.