Thanks to a combination of low-interest rates and investors’ preference for higher-yielding defensive assets, the Utilities Select Sector SPDR (XLU ), the largest utilities sector ETF, is one of the best-performing sector ETFs this year.
Up more than 20% year-to-date, XLU may appear poised for a breather, but some market observers believe the utilities sector can continue trending to the upside.
The utilities sector is one of this year’s best-performing groups, underscoring the notion that many investors will embrace utilities stocks and ETFs during favorable interest rate environments. The Federal Reserve recently obliged by lowering interest rates last week for the second time this year and another rate cut is possible before the end of this year.
“If interest rates keep heading toward 0% and investors continue favoring domestic businesses, utilities could keep rallying. A lot,” said Morningstar in a recent note. “The average U.S. utilities sector dividend yield at 3.3% is 160 basis points higher than the 10-year U.S. Treasury yield as of late September. The yield premium last reached this level in mid-2016. Utilities were up 13% one year later and 17% two years later even while interest rates doubled.”
Investors who are looking for companies to invest in that carry minimal risk will often consider utility stocks. Utility companies typically comprise the most fundamental necessities, such as food, water, and shelter, or are closely related to the energy required to refrigerate food, heat up water and light up a house.
At a time when some sectors are being slammed due to the re-emergence of trade tensions between the U.S. and China, utilities stocks hold some allure for investors because the sector generates nearly all of its revenue on a domestic basis. S&P 500 utilities companies, on average, depending on the U.S. for 95% of their revenue.
The rub with utilities stocks and funds such as XLU right now is that group is getting pricey, indicating costs are elevated for investors looking to play defensive.
“We think utilities investors should be cautious. High valuations erode some of the sector’s defensive benefits if the economy turns. Energy efficiency and customer rate cuts are fundamental headwinds. But for income investors trying to decide between bonds and stocks, high-quality U.S. utilities offer an attractive mix of premium yields and consistent growth,” according to Morningstar.
This article originally appeared on ETFTrends.com