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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

The recent breakout of the benchmark 10-Year Treasury yield from the recent mid-4 percent yield band to approximately 5 percent (with some market expectation that it may increase further) potentially has important strategic and value implications for the power and utility industry.

Power and utility industry valuations before the 2003 dividend tax cut were highly negatively correlated (approximately 0.69) to the 10-Year Treasury yield, which is generally viewed as a proxy for interest rates. 1 This negative correlation between the 10-Year Treasury yield and industry valuations, however, “decoupled” following the 2003 dividend tax cut. The negative correlation inverted to a positive, but nominal, correlation of 0.33 since January 2003, as industry valuations expanded and sustained at historically elevated levels, even as 10-Year Treasury yields increased or remained static (see Figure 1).

This decoupling of the historical correlation between industry valuations and the 10-Year Treasury yield likely was attributable largely to the after-tax yield effect of the 2003 dividend tax cut, particularly relative to Treasury yields. Historically, utility dividend yields and the 10-Year Treasury yield maintained an approximately 1:1 ratio (the “yield ratio”) on average; that is, if the 10-Year Treasury yield increased to 6 percent, industry valuations would adjust accordingly, such that industry dividend yields also were at approximately 6 percent (see Figure 2, p. 26). However, following the 2003 dividend tax cut, utility dividends became taxed at a significantly lower rate (15 percent) than Treasury yields (35 percent), suggesting that the 10-Year Treasury yield needed to be significantly higher than the average industry dividend yield to maintain its traditional yield ratio on an after-tax basis (assuming that the historical 1:1 yield ratio applies on an after-tax basis). 2

Adjusting for this after-tax impact, the implied adjusted pre-tax yield ratio between the power and utility industry average dividend yield and the 10-Year Treasury yield should now have to be approximately 0.76x (the “adjusted yield ratio”). For example, assuming an average industry dividend yield of approximately 3.5 percent, the 10-Year Treasury yield would have to increase, or be projected to increase, to approximately 4.6 percent before the 10-Year Treasury yield again would approximate its historical yield ratio on an adjusted after-tax basis and re-correlate to power and utility industry valuations.

This re-basing of the yield ratio to adjust for the after-tax relative yield effect of the 2003 dividend tax cut likely explains the decoupling of Treasury yields and industry valuations since January 2003. This after-tax yield differential effectively created a period of “elasticity” between industry valuations and Treasury yields as, contrary to historical correlations, industry valuations expanded