Higher interest rates leave less margin for error for markets. But once the Fed is done raising rates, I expect bond yields to come down gradually and the share price of companies like American Electric Power (AEP) to start rising, underscores Jim Pierce, editor of Investing Daily’s Personal Finance.
The opportunity for financial arbitrage is greater when artificially low interest rates allow businesses to borrow money at very low cost. But the risk increases significantly when borrowing costs triple in less than a year.
That is one reason why AEP announced in February that it has agreed to sell its interest in a partnership that owns a portfolio of unregulated renewable assets. The deal should close during the first half of this year, at which time AEP expects to receive $1.2 billion of net proceeds.
According to Julie Sloat, AEP’s president and CEO, “The proceeds from the sale will be directed to the significant pipeline of opportunities we have to enhance service for customers across our footprint and advance our clean energy transition.” The company reiterated its “plans to invest approximately $40 billion over the next five years in its regulated wires and generation business.”
The appeal of regulated assets during a rising interest rate environment is that the utility can factor higher borrowing costs into the rates that it charges customers. However, the rates charged for its unregulated businesses are set by the market.
Presumably, AEP has determined that the ROI (return on investment) for its regulated assets will be greater in a higher interest rate environment. Since the Fed started raising interest rates a year ago, AEP’s share price has fallen from above $105 last August to below $90 by the end of February.
Despite its recent pullback, there is nothing wrong with AEP. Its fiscal 2022 Q4 results released in February came in as expected, and its guidance for full year 2023 results includes a 4% to 7% increase in operating EPS compared to last year.
The disposition of its unregulated business should make it easier for the company to achieve that guidance. The question for investors is how much they are willing to pay to receive AEP’s quarterly dividend of 83 cents per share.
At a share price of $90, that works out to a forward annual dividend yield of 3.7%.
Recommended Action: Buy AEP.