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Co-authored with Hidden Opportunities
From a market price standpoint, defensive sectors like REITs, utilities and telecom have been hit particularly hard as we went through a record pace of interest rate increases. However, due to their defensive nature, the underlying companies demonstrated strong execution, maintained their profitability, and predictably generated free cash flows, but failed to secure better valuations due to the perception of struggle amidst higher borrowing costs. This is about to change shortly.
“The time has come for policy to adjust.” – Jerome Powell, Chairman of the Federal Reserve.
When interest rates drop, the market gets an adrenaline shot. Investors rush into equities, leading to a jump in prices. You may see valuations get richer, even for companies and sectors that are fundamentally weak. It’s important to remember that rate cuts are a consequence of cracks in the economy, and this weakness can and will affect certain sectors harshly. Also, central banks often cut interest rates before or during the early stages of a recession in an effort to stimulate economic activity and mitigate the effects of the downturn. This dovish move is to make borrowing cheaper, encourage spending, and support economic growth amidst signs of trouble.
So, you need something that benefits from rate cuts while being resistant to recessionary pressures. Out of 11 stock sectors, consumer staples, utilities, healthcare, and energy have proven themselves to be the most recession resistant. That’s because their goods and services will continue to experience strong demand regardless of the state of the economy.
We always hear this in the form of comments on our articles
“All stocks plummet during recessions.”
This is not true.
Without shorting the market, you can generate significant capital gains during economic recessions through defensive investments, either through picks that rise during recessions or those that rebound much faster than the broader market. Most importantly, companies in recession-resistant sectors continue dividend payments (and raises) through market weakness, allowing us to collect steady income through the roller coaster.
Amidst slower economic growth, financial uncertainty, rising unemployment, and weaker manufacturing output, we will now discuss two picks from a sector with excellent fundamentals and strong catalysts to support long-term growth and recession resistance through the inelastic demand for their services. Let’s dive in.
Pick #1: UTF – Yield 7.3%
Several US utility companies are reporting supply deals signed with emerging data centers that are powering the AI boom. The CEO of Duke Energy (DUK) mentioned that data centers represent 25% of their growth pipeline through 2028, and the contribution is higher in 2030 and beyond.
Big Tech firms like Amazon (AMZN), Microsoft (MSFT), and Google (GOOG) are all reporting massive investments in reinforcing their cloud services with AI, with plans to collect predictably recurring subscription revenues from their customers.
You can collect monthly income from the strong demand for utilities through an investment in Cohen & Steers Infrastructure Fund (UTF).
UTF is a closed-end fund with electric utility firms representing six out of its top 10 holdings. Source
UTF Fact Sheet
The fund is deeply diversified across 263 holdings, 33% of it is electric utility and 25% is composed of gas distribution, tower, and midstream corporations. Altogether, the CEF holds highly defensive companies with predictable cash flows from inelastic services.
UTF Fact Sheet
Utilities have been experiencing an improvement in valuation since the market got the hint of upcoming rate cuts. We expect this to accelerate in the weeks leading to the first rate cut, and after.
Yardeni.com
UTF operates with 30% leverage, which will boost shareholder returns through multiple sector improvement. 85% of the fund’s leverage is fixed at a weighted average rate of 1.6% for another two years, allowing the CEF to naturally deleverage, supported by its rising NAV. The blended cost of all financing stands at 2.3%.
UTF has paid regular distributions to shareholders since its inception in 2004. year-to-date, the CEF estimates its payments to be 42.6% from NII, and 57.5% from realized long-term capital gains. Its current $0.155/share monthly distribution calculates to a 7.3% annual yield.
Pick #2: Fortis Preferred – Yields of up to 6.9%
Fortis Inc. (FTS) is an international diversified electric utility holding company operating in Canada, the United States, Central America, and the Caribbean. The company operates 10 regulated utilities in 18 jurisdictions, making it one of North America’s most geographically diverse utility businesses. FTS serves 3.5 million electric and gas utility consumers through its extensive network of assets worth $64 billion. 93% of FTS’ assets are associated with transmission and distribution, and 99% are regulated.
Fortis maintains a strong balance sheet with investment-grade A- issuer credit rating from S&P, with ~US$ 190 million in debt maturities in 2024. The company ended Q2 with $625 million in cash and cash equivalents and ample liquidity to handle upcoming maturities. FTS also maintains an impressive 50-year history of continuous annual dividend growth, and the company is projecting a 4-6% CAGR dividend growth through 2028. Source
August 2024 Investor Presentation
Notes: The below securities are primarily listed on the Toronto Stock Exchange, and all prices and values are in Canadian Dollars unless otherwise mentioned. Dividends are declared and paid in CAD, and the amount received by U.S. investors will vary based on conversion rates.
In the past four years, FTS has delivered a 6% EPS CAGR, placing its growing dividend at an average ~76% payout ratio. Consistent with this performance, the company’s $1.60 EPS places its 1H 2024 dividend of $1.18/share at a 73.7% payout ratio.
FTS projects a 6.3% CAGR rate base growth through 2028, indicating steady earnings growth in the coming years, and demonstrating the asset monetization and inflation resistance of the utility sector.
Our focus is on Fortis Cumulative Redeemable Five-Year Fixed Rate Reset Preference Shares Series G (FTS.PR.G:CA), trading as FTRSF on the OTC markets.
Fortis rate-reset preferreds can only be redeemed at every five-year anniversary of their original call date. FTS-G experienced its most recent rate reset on Sept. 1, 2023, and the next will be in September 2028.
“The Annual Fixed Dividend Rate for the Subsequent Fixed Rate Period shall be equal to 6.123% per annum, being equal to the 3.993% yield to maturity of a Canadian dollar-denominated noncallable Government of Canada bond with a term to maturity of five years as quoted as of 10:00 a.m. (Toronto time) on August 2, 2023 on the display designated as page “GCAN5YR Index” on the Bloomberg Financial L.P. service, plus 2.13%.” – Notice to shareholders
This means that its coupon will be reset based on five-year Canadian Treasury yields and stay locked for the next five years. Current discounted price levels of FTS-G offer ~14% upside to par, and a healthy 6.9% yield at cost ($1.53/share annually).
FTS-K (FTS.PR.K:CA) experienced a rate reset on March 1, 2024, and its annual dividend is set to $1.3673 for the five-year period up to but excluding March 1, 2029. At current prices, FTS-K offers a 6.6% yield and 22% upside to par. With the Bank of Canada pursuing aggressive rate cuts, we expect these discounts to shrink significantly in the months ahead, making this an attractive opportunity to lock in elevated yields backed by predictable earnings from a high-quality utility company.
Conclusion
The growing base of power-hungry AI infrastructure will provide strong growth tailwinds for utility companies for years, and the inelastic nature of their services will ensure steady demand through economic cycles. Utility companies’ predictable cash flows and dividend stewardship make them a good fit for income investors, especially when they’re trading at discounted prices amidst elevated interest rates.
Rate cuts are upon us, and it’s important to safeguard your income. At High Dividend Opportunities, we maintain diversified allocations in defensive asset classes like healthcare, consumer staples, REITs, utilities, telecom, and fixed-income securities. Our model portfolio has more than 45 holdings, targeting a 9%-plus overall yield. The stability of income is the cornerstone of our Income Method, making it an essential ingredient in the recipe for a secure retirement.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.