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Interest Rates Strike Back

The old paradigm—a strong inverse correlation of high interest rates and lower utility valuations—once again takes hold.

Fortnightly Magazine - June 2006

potential declining valuation environment may present execution complexities, including important considerations related to value and timing.

While interest-rate considerations are important for the power and utility industry, particularly with respect to valuation, a myriad of other externalities that are not captured in the above empirical data and derivative observations also affect industry trading dynamics and valuations, including the risk that the 2003 dividend tax cut will not be extended, or that it may be repealed. However, the analyses and metrics noted herein strongly suggest that, after several years following the 2003 dividend tax cut where the industry traded relatively decoupled from interest rates, the thumb of interest rates (both positively and negatively) appears to be once again on the scale of power and utility industry valuations.



1. For the purposes of this memo and the analyses referenced herein, the 10-Year Treasury yield is referenced as a proxy for interest rates.

2. For the purposes of this analysis, the 10-Year Treasury yield is assumed to be taxed at the marginal tax rate of 35 percent. Further, this analysis does not adjust or otherwise account for the fact that some power and utility industry investors may be tax indifferent.

3. Treasury yields increased sharply on Jan. 25, 2006, following strong published economic data. The sharp decline in mid-to-long-dated Treasury prices indicated a growing market consensus that U.S. interest rates would begin trending upward and that the Federal Reserve would continue to increase rates, with Federal funds futures moving to indicate a 75 percent chance that the Federal Reserve would increase the target funds rate to 4.75 percent in March after an initial increase to 4.50 percent at its Jan. 31 meeting.