Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / How Rising Short-Term Rates Squeeze Utility Dividends
Transcript
- Lucas: So we've talked a lot this month about how dividend stocks react to different parts of the yield curve. But here's a specific pressure point I think gets overlooked: what rising short-term rates do to utility companies specifically. Luna: Yeah, utilities are usually the classic 'bond proxy' — people buy them for yield. But if short-term rates are climbing, that story gets complicated. Lucas: Exactly. And right now, as of early June 2026, the two-year Treasury yield has moved up to 4.05 percent, while the ten-year is at 4.47 percent. The spread is only about 41 basis points — that's a pretty flat curve. But the two-year is what really matters for utility financing costs. Luna: Because utilities carry a ton of debt. They're capital-intensive — power plants, transmission lines, all that infrastructure. Lucas: Right. A typical regulated electric utility has a capital structure that's maybe 50 to 60 percent debt. So when short-term borrowing costs go up, it hits their interest expense directly. And unlike some other sectors, utilities can't just raise prices overnight — rate increases have to be approved by state regulators. Luna: That lag is the problem. If the Fed holds rates steady but short-term yields keep creeping up — which they have, the two-year went from 3.98 to 4.05 just in the last couple days — utilities are stuck paying more to refinance maturing debt. Lucas: You know, I think a lot of this show's value comes from connecting these macro dots to actual portfolio decisions. If this conversation is helping you think about your dividend holdings differently, the way we keep this ad-free is through listener support — buy me a coffee dot com slash fexingo. It's a small gesture that keeps the show independent. Luna: Yeah, and it really does make a difference. A lot of listeners have chipped in, and it lets us spend time on topics like this instead of chasing ad revenue. Lucas: Alright, back to utilities. So let's look at some actual names. The VYM ETF, which holds a lot of utility stocks, is up 1.5 percent over the last five days — that's actually decent. But some individual utility stocks have been weaker. We've seen names like Duke Energy and Southern Company — they're down in the same period. Luna: And the broader market is flat — S&P 500 is basically unchanged. So utilities are a mixed bag right now. Lucas: The key metric to watch for any utility dividend is the free cash flow payout ratio. How much of the operating cash flow is left after capital expenditures goes to the dividend. If a utility is paying out more than 80 percent of free cash flow as dividends, and short-term rates are rising, that dividend is more vulnerable. Luna: Because if borrowing costs eat into earnings, the company has less cushion. They might have to cut the dividend or slow the growth. Lucas: Right. And we've seen this play out before. In 2022, when the Fed started hiking, some utilities with heavy short-term debt exposure had to trim their dividend growth forecasts. The ones with long-dated fixed-rate debt were more stable. Luna: So what should a dividend investor do right now? Look at the debt maturity schedules of their utility holdings? Lucas: Absolutely. If a utility has a lot of debt maturing in the next 12 to 24 months, they'll have to refinance at current rates — around 4 percent on the short end. That's not crisis-level, but it's higher than the 1 or 2 percent they might have been paying. It's a headwind to earnings per share. Luna: And what about the ETF approach? VYM has a yield around 3 percent. But it holds a mix of utilities, consumer staples, healthcare — so it's less exposed. Lucas: Right. VYM is diversified. But if you hold a pure utility ETF like VPU, you're taking that concentrated risk. The yield on VPU is about 3.5 percent, but the dividend growth rate has slowed. In the last year, the sector's dividend growth was around 4 percent, down from 6 percent a couple years ago. Luna: So the higher yield is partly a signal that the market expects slower growth. That's the classic yield trap dynamic. Lucas: Exactly. And here's another angle: regulated utilities vs. unregulated. Regulated ones have more predictable earnings because their allowed return on equity is set by state commissions. Unregulated ones, like power marketers, have more earnings volatility — and their dividends are less reliable. Luna: But even regulated utilities can get squeezed if the allowed ROE doesn't keep up with the rising cost of debt. That's a political decision. Lucas: Yeah, and some states are more friendly than others. For example, utilities in the Southeast — like Southern Company — operate in states with constructive regulation. But in California or the Northeast, the process can be slower and less generous. Luna: So geography matters. That's not something most dividend investors think about when they buy a utility ETF. Lucas: Right. And the current environment — with the Fed holding the funds rate at 3.62 percent but short-term Treasury yields drifting up — it's not a crisis for utilities. But it's a slow squeeze. The two-year yield has risen about 7 basis points just since the start of the month. Luna: That's not huge, but it's the trend. If the two-year keeps climbing toward 4.25 or 4.5, utilities will feel it more. Lucas: Exactly. And the counterargument is that utilities also benefit from falling long-term rates — if the ten-year drops, their equity valuations get a boost. But right now the ten-year has actually ticked up a bit, to 4.47. So they're not getting that offset. Luna: Let's look at some specific data. The 10-year yield was at 4.45 on May 1, now it's 4.47. The two-year went from 3.98 to 4.05. So the curve is flattening — the spread narrowed from 47 basis points to 42. That's typically bad for utilities because it means short-term rates are rising faster than long-term. Lucas: That's a great point. When the curve flattens, the utility business model — borrow short, invest long — gets less profitable. Their net interest margin shrinks. Luna: So what's the play for dividend investors? Avoid utilities altogether? Lucas: Not necessarily. But be selective. Look for utilities with investment-grade credit ratings, long-dated fixed-rate debt, and strong free cash flow. And consider reducing exposure if you have too much. A 5 to 10 percent allocation to utilities in a dividend portfolio is reasonable. More than that, and you're taking on rate risk. Luna: And maybe prefer the diversified ETFs like VYM over the sector-specific ones. VYM is up 1.5 percent in the last five days, while SCHD is down 0.8 percent — SCHD has less utility exposure actually, but it's been hit by other factors. Lucas: Right. And let's not forget that utility dividends are still growing, just more slowly. The average dividend growth for the sector this year is around 4 to 5 percent. That's not bad — it's just not as high as it was. Luna: So the headline is: utilities are under a short-rate squeeze, but not broken. Investors just need to do their homework on which utilities have the most debt coming due. Lucas: Exactly. And that's the kind of analysis that separates a good dividend portfolio from a great one. It's not enough to just buy the highest yield — you have to understand the capital structure. Luna: Alright, so next time, maybe we look at how rising short-term rates are affecting REIT dividends. That's another capital-intensive sector. Lucas: Good idea. We've touched on REITs in previous episodes, but we haven't done a deep dive on this specific angle. Let's put that on the list. Luna: Perfect. For now, the takeaway: keep an eye on the two-year yield, and check your utility holdings' debt maturities. Lucas: And if you found this useful, buy me a coffee dot com slash fexingo. It helps us keep doing episodes like this.