There’s been a surge of interest in utility and infrastructure stocks and closed-end funds. Utilities and infrastructure are rightly seen as safer havens in turbulent times.
While each of the three CEFs has its stronger and weaker points, I’d consider any of the three to be an excellent vehicle for investing in utilities and infrastructure.
I would either continue adding to my position in UTF or consider waiting for UTG’s rights offering and add to my position in that fund following the inevitable negative.
This report was initially posted to members of Yield Hunting on September 25. All data is current as of that date.
Three Utility CEFs: DNP, UTF And UTG
There’s been a surge of interest in Utility, or more accurately, Utility/Infrastructure closed-end funds (CEFs), on Seeking Alpha recently. I suppose that’s only to be expected with the unsettled state of the stock markets of late. Utilities and infrastructure are rightly seen as safer havens in turbulent times.
The market-beating performance of the utility sector is readily seen in the one-year total-return chart of Utilities Select Sector SPDR ETF (XLU) vs the broader market ETFs.
Or the past two months.
XLU is a solid play for the utility sector. But investors seeking more than XLU’s 2.9% yield will want to look to CEFs. And that’s what I’ll do here, focusing on three CEFs. You may have another one or two you prefer, if so tell us about it in the comments, but it’s my view that these three rank among the cream of the crop.
DNP Select Income (DNP)
Cohen & Steers Infrastructure (UTF)
Reaves Utility Income (UTG)
All three are well established funds and large by CEF standards. DNP is the oldest (inception Jan 1987) and largest (market cap $3.7B) of the three. UTF ($2.3B market cap) and UTG ($1.8B) have been on the market since early 2004.
Let’s begin with a snapshot of the funds as they stand today.
Current market distribution rates range from UTG’s 5.8% to UTF’s 6.8%, double or more than what XLU pays.
Discounts and premiums present an interesting contrast. UTF and UTG are currently priced near par. DNP is carrying a substantial premium.
Data for the above tables are current as of 23 September 2019 and come from cefconnect.com
One consequence of DNP’s hefty premium is seen in the above table on distribution rates. The fund’s premium pulls down its strong 7.2% NAV yield more than a full percentage point to a mid-pack market yield of 6%.
Z-scores give us a picture of how discount/premium status has been changing.
DNP and UTF have been gaining market value relative to their NAVs over the past year. UTG’s recent trend has been to give up market value.
Recent market performance of all three funds is excellent relative to the broad domestic market. DNP has kept pace with the utility sector, while UTF has beaten that benchmark by almost five percentage points. This total return chart shows performance (with distributions reinvested) compared to XLU and SPY.
For a longer term perspective I’ve gone to Portfolio Visualizer, which is the source for the data in the following tables. Here are CAGRs for 1, 3 and 13 years. I selected 13 years (i.e.. From September 2007) to include the great recession and recovery.
All three of the CEFs turn in strong performances with each beating the utility sector ETF. For the short term (1 year) or the long term (13 years) UTG is the top performer although it slides to second place for the past three-year window. DNP lags consistently for this metric.
Investors value utilities for their low volatility. Leverage, of course, takes its toll on volatility as we see in the standard deviations for the periods.
And, the increased risk of the leveraged CEFs becomes clear when we look at maximum drawdowns.
On these measures of risk, DNP rises to the top of the CEFs, turning in results nearly as stable as the unleveraged ETF.
NAV performance over the past year tells a bit of a different story from that of market performance:
While the three CEFs have been beating SPY handily, none has kept up with XLU. This is, of course, an expected result from investments paying out income levels as least twice that of the benchmark. We can fix that and level the playing field by changing the point of view to reflect total return at NAV (i.e. with distributions reinvested).
XLU still shows a strong result. DNP and XLU are effectively tied. UTF lags somewhat and UTG is well behind the benchmark ETF.
While each of the three CEFs has its stronger and weaker points, I’d consider any of the three to be an excellent vehicle for investing in utilities and infrastructure for the income investor. I don’t intend to delve into the details of the funds but I’ll try to give my views on points to consider in choosing among them.
I’ll begin with DNP. Let me first refer readers to a recent analysis of DNP by Juan de la Hoz (here) who’s done a good job of dissecting the fund’s features.
DNP has shown excellent performance stats over an extended period, particularly at NAV which I consider to be the best measure of CEF management performance. Its yield, which falls in the middle of our three-fund pack, is more than twice that of the sector ETF.
The distributions have been solid over a long time frame. The fund is paying $0.0650 per share monthly and has been doing so for the past two decades, with no decreases and an occasional modest end-of-year special distribution earlier in its history. It tends to more moderate levels of volatility. With that combination of consistent high yield and moderate volatility, DNP is a model for the defining appeal of utility investments.
Its big downside is its hefty premium. Some CEF followers make it a rule to not invest in funds at a premium. I am not among them and I have several premium-valued funds in my income portfolio. Even so, I tend to blanch at DNP’s 20%. When I accept a premium valuation it’s because multiple factors are aligned to justify it. These include such things as exquisite management demonstrated by outstanding returns (especially at NAV) over an extended period, category-busting performance either from income yield or capital appreciation, a unique approach or position that other funds are unable to replicate, or, in some cases, recent declines from even higher premiums (seen in deeply negative Z-scores) that appear to have moved the fund into an attractive valuation despite its premium. In this regard, several of PIMCO’s CEFs would be the poster children for funds to buy despite their premiums.
I’d not argue that DNP’s management is not among the very best in its category; clearly it is. But I’ll not concede it any of the other points that might justify its market premium. While NAV yield is especially strong, the premium drags yield to investors down to only modest levels in relation to its peers. Capital appreciation has been strong, but again, not sufficiently so to justify a premium valuation 20% greater than the other two funds. And, finally we’re not seeing a declining premium. The Z-scores are telling us just the opposite, the premium has been growing consistently over the past year, so it's not a fund that is a potential bargain despite carrying a premium.
One point potentially in DNP’s favor is that it is holding $2.45 per share in undistributed net investment income (UNII) according to cefconnect. This is dated as of 31 October 2018, so it is stale data (not unusual for CEFs as reported by cefconnect). Furthermore, UNII at this level would seem to dictate a hefty special distribution on the horizon, but that did not happen for 2018. Throughout DNP’s history there has only been a few modest special distributions, and none since 2005.
I’m not sure of the history on this large pool of UNII, perhaps some reader can enlighten me on it, but for the April, 2019 semi-annual report, DNP shows a total distribution of $0.39 per share, only $0.10 of which is covered by net investment income, and no net realized capital gain. Distributions over that period were $0.29 in excess of NII and capital gains. Even so, it will take more than four years to go through $2.45 UNII at that pace. My view here is that anyone attracted to DNP may want to do thorough due diligence on its UNII.
But, good though the fund may be, I’d avoid it unless and until the premium falls substantially, something I do not foresee happening. The last time the premium fell below 5% was in mid-2016.
Let’s turn to UTG. UTG has the lowest yield of the set, lagging DNP's by 22 basis points and UTF's by 99. But UTG is also the only fund of the three that has consistently increased its distribution. And it does periodically pay substantial special distributions. It is reported as having -$0.6496 UNII per share (as of April, 2018) by cefconnect, so it does not seem likely to be headed for another special distribution for 2019.
The most important point separating UTG from the other two funds is that it holds regular rights offerings, something that many CEF observers dislike. This can be a strong negative for a buy-and-hold income investor who is not interested increasing the size of holdings in the fund. It is, perhaps, less of a concern to those prepared to fully participate in UTG’s rights offerings and may offer the opportunity to increases one's position size at a substantial discount.
At one point I calculated IRR values for investors who fully participated in UTG’s rights offerings in 2012, 2015 and 2017. I started my analysis July 1, 2012, just prior to the 2012 rights offering, taking the full brunt of the market's reaction to the offering. I ran it through July 2019 to include the three offerings and a period of recovery. Investors who participated by buying one additional share for each three shares held each time saw an IRR of 12.92%. Investors who oversubscribed to the maximum level saw an IRR of 13.48%. Respectable returns by any measure.
The straight buy and hold investor who sat out the rights offering collected a 11.35% return for the period. Not bad, but the shortfall reflects the toll of the dilutive expansions of the fund. The strong message here is if one is inclined to hold UTG in an income portfolio that intention should come with a willingness to add to the position every two to three years.
A more telling comparison, though, is to the fund’s comps. As expected, UTG investors did better than XLU (10.91%) whether they participated in the rights offering or not. But a buy and hold investment in UTF for the July 2012 through July 2019 would have a CAGR of 14.93%, beating even the maximum over-subscriber in UTG’s rights offerings.
This is a timely concern for any looking toward a new investment in a utility CEF because UTG would seem to be due for yet another rights offering in the near future. The last one closed in October 2017, 22 months after the previous offering in December 2015. Recall that UTG is the only one of the three funds with negative Z-scores and recent cooling in its share price trajectory. I’d suggest some of this has been driven by investors leaving the fund in anticipation of a rights offering announcement shortly.
Finally, there’s UTF. UTF is, by some measures, the best performing fund of the set. Its market yield is the highest of the three funds by 77 to 99 basis points. And it is selling at par, which makes it more attractive than DNP, but—as the Z-scores tell us—is higher than the fund has seen for some time (apart from a brief period at a small premium in recent weeks).
Until recently, I have been adding to my UTF position. It would be my recommendation among these three funds.
This leads me to my final point: Is an investment in a utility sector CEF even advisable at this time? The sector has experienced a strong run up in 2019 (see charts at the top of the article) as investors seek safer havens in these volatile times. Is it realistic to see this momentum continuing?
I can’t say. But If I were to add to my own utility sector holdings, which I am not, I would either continue adding to my position in UTF or consider waiting for UTG’s rights offering and add to my position in that fund following the inevitable negative toll on the share price from the offering. The most opportune time should be soon after the rights offering closes. I would definitely shy away from DNP as nothing I see there justifies the 20% premium that is the fund’s cost of entry.
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Disclosure: I am/we are long UTF UTG. 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.