August 13, 2015 / 3:12 PM / 3 years ago

Utilities ETF hedging dwindles as U.S. rate-hike timing remains unclear

NEW YORK, Aug 13 (Reuters) - A Fed “lift-off” later this year is a worry for the rate-sensitive utilities but the sector’s underperformance this year and continued uncertainty about likely timing of the hike has led to a dramatic drop in hedging activity in the sector.

The S&P 500 index of utilities, used as a bond proxy by investors in a low-rate environment, fell about 14 percent over the five months ending June. The sector has logged a 5 percent decline for the year, compared with a gain of about 1 percent for the S&P 500.

Utilities, with high dividend yields which help attract investors, are one of the more rate-sensitive sectors and an increase by the central bank would hurt their appeal to investors.

“Utilities valuations have come down from earlier this year and from where they were trading for much of the 2011-to-2013 time frame, but the rate hike does not look completely priced-in,” said Jill Carey Hall, equity strategist at Bank of America Merrill Lynch, who is underweight the sector.

The sharp drop in defensive bets, at a time when the Fed is widely expected to start raising rates soon, may leave investors exposed in case the sector suddenly takes a turn for the worse.

Trading in the options on the Utilities Select Sector SPDR exchange traded fund, however, shows a dramatic drop in hedging activity since the end of June.

Open contracts are nearly equally spread between bullish calls and bearish puts.

This represents about the lowest level of open positions in puts relative to calls this year, down significantly from January when there were six puts open for each open call.

“The reason people are not hedging any more is based on the market’s assessment of when the Fed is going to raise rates,” said George Hashbarger, portfolio manager at BPV Wealth Preservation Fund, in Knoxville, Tennessee.

“As the estimate for the timing of the raise gets pushed out, people feel less of a need to hedge.” he said. “I think there’s a little bit of complacency.”

Expectations for a rate hike have been pushed from June to September or later.

Much of the hedging activity was timed to capture the Fed’s policy statement in June and has expired since.

“The Fed’s forward guidance at its June meeting signaled a slower pace of future rate hikes, and hence less likelihood for sudden downside in the ETF. This may also explain the drop in hedging activity,” said Pravit Chintawongvanich, derivatives strategist at Macro Risk Advisors in New York. (Editing by Matthew Lewis)

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