Utility sector income stocks and the bond yield spike 

Typically a haven sector during troubled times, UK utility shares have been hit hard in recent weeks. Graeme Evans explains why and which companies this expert is tipping.

Income-focused investors whose shelter in the utility sector has been breached by rising bond yields and the energy crisis, were given some reassurance by a City bank today.

Deutsche Bank believes several stocks in European utilities continue to offer attractive returns, including renewables company SSE (LSE:SSE) and water firm Severn Trent (LSE:SVT).

Its assessment follows a buffeting for share prices as the cost of capital rises and firms face regulatory interventions from governments looking to claw back windfall power gains.

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These factors have contributed to Deutsche Bank making an average 13% cut to target prices across its European coverage of the utilities sector, but for most of the integrated energy players such as SSE, E.ON SE (XETRA:EOAN) and RWE AG (XETRA:RWE) their revised earnings projections are still higher than pre-crisis.

Deutsche Bank cut its SSE target price from 2,000p to 1,900p but this compares with today’s new 52-week low at 1,450.5p after the UK government confirmed plans for a temporary revenues cap for power generators.

Recent selling in the regulated water sector has been just as severe, reflecting rising debt costs and as higher interest rates encourage investors to look elsewhere for returns.

Severn Trent shares have fallen by a fifth in the past month to 2,224p, but today’s research highlighted a new target price of 3,000p, down from 3,300p previously.

The bank has “hold” recommendations on United Utilities Group (LSE:UU.) and Pennon Group (LSE:PNN), with new lower target prices of 1,000p and 880p respectively.

It points to the near-term earnings impact of inflation in the UK water sector as there is a lag between higher costs being incurred and these getting passed through in revenues.

Deutsche Bank also assumes that companies will have to forgo some of their potential price rises into the next regulatory period from 2025/26, due to the cost-of-living crisis.

Yields for the three water companies are projected at between 5% and 6% in 2023, but Deutsche Bank favours Severn Trent on the grounds that it should target at least inflationary dividend growth and deliver a strong performance under its regulatory framework.

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For SSE, the bank has increased its earnings estimates over the next three years by 12-14% to reflect higher profits from its renewable and gas-fired power stations.

Its 2022/23 estimate is 23% above the City consensus and 2023/24’s 15% above, but this drops to only 3% above in 2024/25 as SSE agrees to voluntary fixed priced contracts for its renewables production. The projected 2023 dividend yield is 4%.