Bond yields are retreating, and that bodes well for these cheap income-paying stocks in 2024

Published Mon, Dec 18 20232:08 PM ESTUpdated Mon, Dec 18 20232:52 PM EST

Utility stocks are selling for bargain prices at the end of 2023, and several of them are looking like good buys for the new year. The group is off about 10% year to date — the worst of the 11 sectors in the S & P 500 . By contrast, the broad market index is up 23% in 2023. The Federal Reserve's rate-hiking campaign put utilities under pressure starting early last year, subjecting companies to higher refinancing costs and making their dividends less attractive relative to Treasurys. The utilities act like bond market proxies, and tend to see falling prices as rates rise . Now, however, utilities are enjoying a rebound — up 2% in the past month — as the 10-year Treasury yield retreats. The benchmark yield is at about 3.9% today, down sharply from its October highs when it breached 5%. "It's been a historically bad 2023 for the utilities, but we think there are some silver linings," said Travis Miller, energy and utilities strategist at Morningstar. "We think finally investors have a chance to buy into utilities with dividend yield — and on top of that, utilities have stronger balance sheets and stronger growth prospects than we've seen in more than a decade," he said. Tailwinds into 2024 and beyond The "higher for longer" theme for Federal Reserve rate policy this year had challenged utilities' appeal among investors. Lately, a pullback in yields is starting to unfold, and the Fed signaled last week it expects to cut rates three times next year. "Here, we track a recent uptick in generalist interest in the group and see a stabilizing/falling rate outlook as a key catalyst for multiple expansion," JPMorgan analyst Jeremy Tonet said in a report last week, referring to price-to-earnings multiples. He noted that moderating inflation should also help the sector. Utilities also have a long-term tailwind due to green initiatives, such as the Inflation Reduction Act. The measure includes tax incentives for renewable energy. "Enhanced with IRA support, technological advancements have propelled a renewable energy generation transition, creating a deep investment opportunity set buoyed with associated grid build-out needs to maximize and optimize renewables deployment and enabling stronger rate base and EPS growth," Tonet said. Finally, a lot of the pain tied to higher rates has already been priced in, said John Baldi, portfolio manager at ClearBridge Investments and co-manager of the firm's Dividend Strategy Fund (SOPAX) . He noted that 2024 earnings expectations for utilities haven't changed much, and long-term interest rates have been a driver of underperformance for the sector. "If rates go down, there's an opportunity for a rerating of the sector that's more in line with its historical relative valuation because it has effectively prefunded some of the pain associated with higher rates," Baldi said. The risk facing utilities in 2024 is that higher financing costs may mean companies will have to limit their plans for growth, Morningstar's Miller said. Indeed, some companies that are investing in the clean energy transition may need to issue new equity, and balance sheets for some companies look stretched, according to UBS. Finding the right plays To that end, Baldi's fund added exposure to its two utilities holdings this year: Sempra Energy and Edison International , citing reasonable valuations and an attractive yield. Sempra has operations in California and Texas, and shares offer a dividend yield of 3.2%. UBS rates the stock a buy and doesn't expect Sempra to have to sell stock in 2024. Shares are off more than 2% in 2023. Edison International is headquartered in California and yields 4.5%. The stock is up nearly 10% this year. Miller of Morningstar called out Indiana-based NiSource as one of his picks. "We don't think the market appreciates the earnings growth potential for them over the next five years," he said. NiSource pays a dividend yield of 3.8% and provides gas distribution and electric operations in the Midwest. Shares are off 3% in 2023. JPMorgan's Tonet also called NiSource a top pick for 2024, citing the stock's "favorable thematic qualities with an outlook already [reflecting] inflation and high interest rates." The bank also pointed to NiSource's 6% to 8% annual EPS growth. "Overall, there are few names across our coverage that offer this balance of quality and growth, which we expect will stand out amid new interest in buying the space after 2023's 'sell the group' paradigm," Tonet said. Entergy is another utility Miller likes, along with Duke Energy of North Carolina. New Orleans-based Entergy "trades at a discount to the rest of the group and pays well over 4% yield, a very attractive combination for investors," he said. Wells Fargo rates Entergy overweight. "We think ETR has one of the more compelling narratives in the sector — the expansion, decarbonization and electrification of the company's Gulf Coast industrial customer base," said analyst Neil Kalton. Shares are off nearly 10% in 2023, but the dividend yield is 4.5%. — CNBC's Michael Bloom contributed reporting.