Today I’ll look at the Utilities sector. With a distribution yield of 5.5% for the sector, it’s easy to see how the distributions can act as a buffer to market volatility.

Here are my answers to a number of questions:

What do investors need to know when investing in the utilities sector?

The utilities sector is a small one on the Australian market. There are only 5 companies that make up this sector. Utilities companies tend to have stable cash flows. Often, they are restricted in types of price rises they can enforce. We call this a regulated industry. Due to the stable cash flows and high depreciation costs of capital investment, they have huge amounts of debt, when measured against traditional measures, such as equity or earnings.

What is the outlook for this sector?

This sector is thought of as a bond proxy. It means as global interest rates rise, share prices can come under pressure. Higher longer-term interest rates would be a negative while lower long-term interest rates would be a positive.

While transmission and distribution of gas and electricity will continue to be important in Australia, emerging technologies will also pay a growing part. Battery storage, smart devices and home energy management systems are all emerging areas, with the potential to disrupt the industry. As other sectors have seen disruption take hold, utilities are expected to be changed substantially over the next decade.

What are the key risks?

There are a number of risks and I’ll go through them.

• Interest rate risk. As this sector is seen as a bond proxy due to the large amounts of debt required for investing into the infrastructure, higher longer-term interest rates are a negative for share prices.

• Regulatory risks. This sector is mostly a regulated sector, where the growth in revenues is restricted by government-imposed limits. Changes in energy policy also occur relatively frequently and can have a large impact on sentiment and share prices.

• Change in demand. Reduction in demand can impact on revenues

• Disruptive technologies. Like many industries, the utilities sector is also prone to disruption from battery storage solutions for households, home energy management systems and smart devices.

What’s your favourite stock in the sector?

My favourite is AGL. This is an integrated energy company and owner as well as an operator and developer of renewable energy generation in Australia. AGL has been sold off due to concerns around regulatory risk and the lower oil price. These concerns look overdone and AGL shares hold value at these levels. I would expect to see the share price move closer to the $22 level and look for an exit. With increased regulatory risk and disruption on the horizon, this has become a higher risk sector than has traditionally been the case