Diving Into The >2% Expense Ratio On The DNP Select Income Fund

About: DNP Select Income Fund (DNP)
by: The Balance of Trade

DNP's expense ratio initially strikes one as hefty.

It comes down to cost of funds in pursuit of leverage. I break down the sources here.

Advisor&Admin ER closer to 1%, and thoughts on the nature of the leverage used by DNP.

Earlier this year (May 2019), fellow SA contributor RockEstra Research published a piece on the Duff & Phelps DNP Select Income Fund (DNP).

This piece will answer why the expense ratio - currently above 2% - is so high on this fund.

Quick Intro to DNP

First, a quick snapshot of the fund to get readers up to speed.

DNP holds nearly $4 billion in AUM, and holds a mix of equity and debt instruments. Most of the equity holdings are in the utilities, energy and communications sectors:

Source: Morningstar

The Fund fact sheet states the following:

Under normal conditions, more than 65% of the Fund’s total assets will be invested in securities of public utility companies engaged in the production, transmission or distribution of electric energy, gas or telephone services.

DNP has generated strong returns for shareholders over the last decade:

Source: Yahoo Finance - Compiled by Author

A final notable point before addressing the expense ratio is the steady monthly dividend of $.065/share, which amounts to about a 6% yield on the current traded price.

Source: SA Essential

An explanation of the Expense Ratio

SA reports the expense ratio on this fund as an eye-popping 2.31%. That's not something investors should take lightly when considering a purchase!

In a previous piece that I published on DNP, I noted that the risk-return profile looked interesting. On account of that, I wanted to get more insight as to why the ER was so high.

Mostly, It's Interest Expense Associated With Leverage

The use of leverage enables the Fund to borrow at short-term rates and invest in higher yielding securities. As of April 30, 2019, the Fund had $1 billion of total leverage outstanding which consisted of: 1) $168 million of floating rate preferred stock, 2) $132 million of fixed rate preferred stock, 3) $300 million of fixed rate secured notes and 4) $400 million of floating rate secured debt outstanding under a committed loan facility. On that date the total amount of leverage represented approximately 26% of the Fund’s total assets.

- DNP Apr. 30 SemiAnnual Report, Pg. 3

As stated above, DNP Select Income carries about $1 billion in liabilities on its balance sheet. Here's the most recently available (unaudited) statement:

Take a look at the fund's semiannual report linked above for a full list of the fund's holdings were back in late April (pp 5-7).

DNP's Liability Profile

According to the semi-annual report, the $400 million in secured borrowings (Line 1 in Liabilities above) is under the following terms (emphasis added):

Interest is charged at 3 month LIBOR (London Inter-bank Offered Rate) plus an additional percentage rate of 0.90% on the amount borrowed. The Bank has the ability to require repayment of the Facility upon 179 days’ notice or following an event of default.

For the six months ended April 30, 2019, the average daily borrowings under the Facility and the weighted daily average interest rate were $400,000,000 and 3.58%, respectively. As of April 30, 2019, the amount of such outstanding borrowings was $400,000,000 and the applicable interest rate was 3.48%.

- DNP SemiAnnual Report, Pg. 18

These notes are tied to 3-month LIBOR, which has been in decline for 2019. With the Fed likely to cut rates further, DNP's cost of funds is likely to fall over the next four quarters.

Chart Data by YCharts

Fixed-Rate Liabilities

In 2016, DNP took on approximately $300 million in fixed-rate debt. The maturity dates are for July 2023 and July 2026. Rates were still quite low in July 2016 (the 10-year UST, for instance, hit what at least for now remains an all-time low in that month).

Mandatory Redeemable Preferred Securities

Source: DNP SemiAnnual Report, Pg. 19

The Redeemable Preferred shares that DNP has issued increase the cost of funding relative to the pure debt instruments (recall the $400 million at 3M+.90%), but also gives the fund more flexibility in timing payment in the event that things hit a snag.

Putting It All Together

Source: DNP SemiAnnual Report, Pg. 14

The operating expenses of the fund, absent the leverage costs, were significantly lower than what they were reported as at the end of April. The non-leverage ER computes to about 1.02%, which some may view as still too high but certainly more reasonable than the initial sticker shock.

At least for now, the fund's cost of borrowing is quite low. I'll observe that between the assets that DNP owns (rate-sensitive assets such as utilities), combined with the leverage (mostly floating-rate), this fund could certainly take a hit if rates were to climb precipitously.

As a final quick breakdown of how the non-leverage portion of the ER is calculated, I'll share Morningstar's summary:

The question that you need to grapple with as a prospective investor is to what degree you are willing to court leverage in the first place. I like the liability profile on DNP, as it is diversified between different instruments and not overdone.

As always, I encourage you to share your thoughts and insights on this topic. SA has a deep bench of readers, and I'm sure you'll agree that frequently the contributor's piece acts as a catalyst for meaty discussion.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.