Sector isn’t cheapest place to park money, but right now a compelling enough argument seems to be that there are few alternatives

Rising interest rates and inflation are typically a circuit breaker for richly valued utility stocks, but these are unusual times.

The sector is the second-best performing one in the U.S. behind energy year to date, trouncing the S&P 500 by 15 percentage points through Friday. That leaves utility stocks trading at almost 20 times forward 12-month earnings on average—close to an all-time high and nearly a fifth richer than the S&P 500. The last time utilities fetched such a large premium was during the Covid-19 market panic in March 2020. The staid sector has typically traded at a slight discount to the broader index over the past decade.

As markets fear a recession, being in the business of collecting monthly checks is understandably appealing to investors. Cash-strapped consumers are more likely to pull back on eating out or shopping before risking that the power or gas will be shut off. And, by some measures, utilities look more defensive today than they have in past years, according to Jay Rhame, chief executive officer of Reaves Asset Management, which manages utility exchange-traded funds. In recent years, utilities have become much simpler, having sold or spun off units that are riskier than or less related to their regulated, monopoly business. Exelon, for example, spun off earlier this year a business unit that has exposure to competitive electricity markets. CMS Energy last year sold off a bank subsidiary.

Still, the sector’s rally is something of an anomaly given the macroeconomic environment. Utility stocks tend not to take well to rising interest rates for two reasons: First, utilities have large debt burdens, with those in the S&P 500 on average carrying net debt that is more than five times earnings before interest, taxes, depreciation and amortization, according to S&P Global Market Intelligence. Second, they are a bond substitute. When interest rates rise, utilities’ dividend yields start looking less attractive compared with Treasurys. At one point during the early-2020 recession, the dividend yield on utility stocks was nearly 4 percentage points higher than the yield on 10-year Treasury notes. That edge is now just 0.17 percentage point.

In addition, high inflation tends to be bad news for utilities. When inflation starts pushing up overall costs for households, it becomes harder to persuade utility regulators to grant higher rates. Regulators are typically either appointed by governors or elected, so they aren’t immune to the sentiments now prompting politicians to blame companies—ranging from oil producers to supermarket chains—for causing consumer pain.

“Price caps, as seen abroad in the U.K. and elsewhere, have strained companies’ ability to successfully invest and earn at full ROE," wrote Nicholas Campanella, equity analyst at Credit Suisse, in a report, referring to return on equity. He added that such moves don’t seem likely in the U.S. just yet, but that they are worth monitoring. At the moment, though, the fear regarding inflation’s destructive effect on fixed-income investments might be overriding the other inflation problem.

“At least with utilities, you get a growing income stream. And you’d think that the utility income stream could be better in an inflationary environment than a fixed-income stream," said Mr. Rhame.

The question is just how much those streams will be pinched by high interest rates and inflation. Moreover, industry-specific clouds also loom over the sector, including the lost momentum in Congress for what was widely known as the Build Back Better package, which included clean-energy incentives. The most recent roadblock is the U.S. Commerce Department’s investigation into whether Chinese solar producers are circumventing solar tariffs—a development that could substantially delay new solar build-out plans. Because utilities’ returns in large part are based on how much they spend on the grid, delays to spending plans can damp earnings growth.

With investors seemingly finding new worries around every corner lately, the forces holding the rest of the market back can make utilities look like a hidden jewel one moment and a lump of expensive coal in the next. In a softening stock market, though, these power lines are starting to look stretched.

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