Rate risk in the utilities sector

Posted: Feb. 25, 2018 -

Last week the FT published an article titled: Rising interest rates punish US power sector.

It is well known that utilities tend to underperform when interest rates are expected to rise. These companies rely on regulated assets to generate their income, making their earnings and dividends more predictable: they tend to behave more like bonds.

The article also cites various companies that might get affected, such as Duke, FirstEnergy, Exelon, NextEra and American Electric Power.

We showed in our last blog how Everysk can calculate and propagate the impact of a rate hike to any security (not just fixed income). We essentially shocked the 10 year rate and calculated the expected profit and loss (P&L) of a $1 invested in various securities. The ability to perform these type of calculations, i.e. to propagate the risk of a shock to securities that do not depend directly on the exogenous shock for their pricing, is called transitive risk.

In this post, we use another important feature of our API: factor modeling. We go one step further from our last post, and not only quantify the P&L impact of a rate rise on stocks from the utility sector, but we also qualify that impact, decomposing how much is explained by rates (we use the 10- Year Treasury Constant Maturity rate published by the Fed) and how much is residual.

We wrote a simple code with our API (available upon request) to rank the top 100 dividend paying stocks according to their forward looking "rate sensitivity", conditional on rates rising. We used an instantaneous shock on 10 year rates of +50bps. The top 5 stocks are all from the Utilities sector:

Company Symbol 10yr Rate Residual Total P&L impact % 10yr Rate to Total
Duke Energy DUK -5.94% -3.42% -9.36% 63.5%
Alliant Energy LNT -6.49% -4.01% -10.50% 62.8%
XCel Energy XEL -6.08% -3.95% -10.04% 60.6%
National Grid NGG -5.96% -4.14% -10.10% 59.01%
NorthWestern NWE -5.88% -4.09% -9.97% 58.9%

So, if rates were to rise 50 basis points, Duke Energy would have an expected shortfall (CVaR) of -9.36%. This is a "worst case" expected P&L. Of that impact, -5.94% would be explained by the 10 year rates (63.5%) and -3.42% by residual, idiosyncratic risk. Despite Duke not having the largest P&L correction, it has the largest rate risk when rates rise.

Contact us to explore how our API can be used to reliably identify securities in your portfolio that are vulnerable to a rate rise.