DNP - BUI Vs. DNP: One Clear Winner Amongst Utility CEFs

2023-12-04 18:00:00 ET

Summary

• We had rated DNP a Strong Sell, as the fund had a toxic combination of leverage and premium to NAV.
• DNP has dropped sharply and thesis has been validated.
• We compare this with another fund, BUI, and tell you why we prefer the latter.
• We also tell you why we are giving DNP an upgrade.

The absurd is not a self-limiting phenomenon. What is ridiculous, can get even more ridiculous. Investors use price as the primary anchor point and hence they create their own delusions and self-fulfilling prophecies. But investing requires looking past the hype and the absurd to drill to the valuation. We did do that with DNP Select Income Fund ( DNP ) some time back. For us, this was so high on hype, that the risk-reward was extremely skewed. The market has finally agreed and "the yield is safe" crowd is smarting from a 33% underperformance.

We look at this one today and compare it with what we think should still do better from here. BlackRock Utilities, Infrastructure & Power Opportunities Trust ( BUI ) is our contender and one that we think can outperform DNP over the next 3 years. To make our point, we will weigh the two against each other on four criteria.

Leverage

DNP has close to $4 billion in assets under management, with approximately a fourth of it purchased using borrowed funds. The leverage is in the in form of $132 million preferred stock, $773 million in secured credit facility borrowings and $200 million secured notes. The rate on the preferred stock and secured notes is fixed at 4.63% and 3%, respectively. Whereas, the drawings from the credit facility are charged at daily Secured Overnight Financing Rate or SOFR, plus an additional 0.95%. This comes to around 6.28% using the recent SOFR numbers.

This number was 5.76% at April 30, as per the semi-annual financial report of this fund, and predictably was even lower at October 31, 2022 (4.65%). The annualized expense ratio on the April 30 financial report was 2.69%, with 1.67% attributed to interest expenses.

Based on the trajectory of the interest rates since April, we estimate this to be higher when the year ending October 31 numbers are published. Our current extrapolation is closer to 3% for the next 12 months.

BUI's annual operating expenses are a tad over 1%, most of which is management fees. That is it.

No pesky interest costs as this closed end fund does not use leverage. We are sticking with our theme here of "lower for longer", as in lower leverage is better until we have a truly epic blow-up in the markets. So BUI wins easily here.

Performance

DNP worked hard to enhance returns using leverage and the market happily paid a premium to hold it for majority of the fund's existence. It has levitated (as measured by premium to NAV) for almost all of the last decade, unlike BUI that has found the market's favor on occasion only. DNP's 10 year performance is not bad at all, but the unleveraged cream BUI caught up in the in the last three years.

BUI did not have the benefit of leverage throughout the ZIRP era and also suffered thanks to a strong US Dollar (BUI goes more overseas than DNP). The fact that the NAVs have kept up with each other speaks volumes about BUI. What we see is an unlevered fund providing close to the same returns without subjecting its investors to the gyrations of the interest rates and risk of amplifying the downturn. BUI wins hands down here though the numbers suggest this was close.

Covered Calls

BUI uses covered calls to enhance returns. This is done at a modest level and not mechanically on the entire portfolio.

As we have recently shown, that latter method is one of the worst ways to generate "yield". BUI's method is one we can get behind and it is likely add a modest amount of alpha in the next bear market.

DNP does not use covered calls.

Premium-Discount To NAV

Premium compression is a great teacher and DNP, while not hauled through the coals yet, has certainly got a taste of it since 2020. In terms of total returns on NAV, DNP is still slightly ahead as shown above. But when we compare total returns on price, is where we see the price investors paid for bidding this up to a silly premium.

It would be great to declare victory and move on. After all DNP's premium which was 31.63% when we wrote about in March, is now just 11.95%.

Interestingly enough, BUI is trading at a sweet discount, thanks to the hatred for utilities at present. The spread between them is currently 16.60% (DNP 11.95% premium, BUI 4.65% discount).

We think at a minimum we will see that compress to 5%. We got under that on three different occasions in the past decade and are due for a fourth.

Verdict

But what about my yield? Yes of course, this exercise would not be complete without addressing the "yield". DNP does pay more than BUI, which is why we are even having this discussion.

What we need to focus on is that DNP's yield on NAV is now 9.9% and far more likely to get cut than in any other timeframe in the fund's history. BUI is paying just 6.7% on NAV and we think is this sustainable for fund using zero leverage and supplementing with covered calls. You can of course reach for yield and the promise that the past is always the future. We don't believe it will work out in the medium term. In the short term, the Z-score on DNP has really blown up. A big negative number here suggests that the fund is currently priced cheaper than it has been in the past.

So there is some risk of DNP rebounding here. We are upgrading this to a "Hold", from a "Strong Sell", but still backing BUI (rated Buy) for the next few years.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

For further details see: