PDO - DNP: Top 10 Big-Yield CEFs

2023-07-18 01:56:28 ET

Summary

• We share updated data on more than 10 of the biggest and most-popular big-yield CEFs, many of them paying distributions monthly.
• After reviewing seven important questions to ask before investing in any CEF, we consider current market conditions and macroeconomic risk factors.
• We have a special focus on the DNP Select Income Fund, which is known for safety and stability (thanks to its utility sector and investment-grade bond allocations).
• We conclude with our strong opinion on investing in the current market environment, plus more information on all of our current big-yield CEF holdings and rankings.

If you like big steady income payments, closed-end funds ("CEFs") are worth considering. In this report, we share important metrics on more than 10 of the biggest and most popular "big-yield" closed-end funds (many of them paying monthly), as well as seven important questions to ask before investing in any closed-end fund. After considering current market conditions, we dive deeper into the DNP Select Income Fund ( DNP ), one of the biggest and most popular CEFs (for good reason). We conclude with our strong opinion about investing in select CEFs in the current market environment, as well as more information on our current big-yield CEF holdings and rankings.

About CEFs:

CEFs are basically pooled investment vehicles (they can own many individual stocks or bonds for example) that trade on an exchange under a single ticker, thereby offering some instant diversification benefits. However, they come in a wide variety of shapes and sizes, and have multiple nuances that investors should consider, as you can see in the following table.

( PDI ) ( NEA ) ( CSQ ) ( UTF ) ( PTY ) ( UTG ) ( GOF ) ( BMEZ ) ( USA ) ( RQI ) ( RVT ) ( PDO ) ( SPY ) ( BND )

We'll get into more specifics about the data in the above table when we dive into the details on the DNP Select Income Fund (later in this report), but just so you have an idea, here are "7 Big-Yield CEF Questions" worth asking before investing in any fund.

You can get a feeling for some of the above questions in the data table immediately preceding it, and we'll dive into more details using DNP as an example (later in this report).

Current Market Environment

Investors always ask, "where is the market heading next?" And because there is such high demand for answers to that question, pundits often answer it. For example, the internet is in no short supply of articles telling you just exactly where the market is headed next. However, the problem is that no one really knows.

Rather than relying on mysterious crystal balls and psychic powers, investors are far better off focusing on their own specific investment goals as well as current market "risk factors." For example, if you cannot stand the volatility of the stock market, you may not want to invest in the Adams Diversified Equity Fund ( ADX ) in our earlier table (even though it is a great fund!) because it owns stocks (many of them significantly volatile) and the strategy may not be right for your own personal investment situation.

Secondly, with regards to market risk factors, here are a few that you may (or may not) want to consider, starting with the market " greed index ."

As you are likely aware, the stock market has been strong this year, and investor greed is currently high. Some see this as a risk factor and use it as an indication that they may want to take some profits now (depending on their own individual goals and situation) instead of continuing to be greedy (greed is often considered a contra-indicator that the market is overheating and due for a sell off).

Another risk factor, especially for bond funds, is current interest rates. As you know, when rates rise (like they have been over the last two years), bond prices fall (exactly what we've seen for bond CEFs in our earlier table).

However, in a good sign for bond funds, interest rate hikes are now slowing and expected to end this year (and even reverse lower next year). And for a little more perspective, here is a look at just how bad bond returns were last year (as rates were rising so rapidly).

Also worth considering, stock market "fear" is currently very low, as measured by the market "Fear Index" ( VIX ).

Some investors view low fear as an "all clear sign" while others view it as an eerie indication that the market may be getting a little too confident. In our view, it depends on your individual goals (including your tolerance for volatility and your investment time horizon). And then you can select investments (such as the one we describe below) based on your own individual investment situation.

DNP Select Income Fund ( DNP ), Yield: 7.6%

The DNP Select Income Fund is an income investor favorite, offering a steady monthly distribution (current yield: 7.6%) by investing in utility sector stocks and investment grade bonds (both known for safety and steady income). However, the shares currently trade at a large 22.9% premium to the fund's net asset value ("NAV"). And the fact that so many people continue to invest in this fund, despite the massive premium, suggest it's worth a closer look, as we do in the following paragraphs.

About DNP:

According to the DNP website :

The DNP Select Income Fund Inc. is a diversified, closed-end management investment company that first offered its common stock to the public in January 1987. The Fund's primary investment objectives are current income and long-term growth of income. Capital appreciation is a secondary objective…

The Fund seeks to achieve its investment objectives by investing primarily in a diversified portfolio of equity and fixed income securities of companies in the public utilities industry. The Fund's investment strategies have been developed to take advantage of the income and growth characteristics, and historical performances of securities of companies in the public utilities industry.

Here is a look at the fund's recent holdings.

( CNP ) ( SRE ) ( AEE ) ( XEL ) ( LNT ) ( PEG ) ( CMS ) ( AEP ) ( WEC ) ( SO )

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…

The Fund may invest in the securities of domestic and foreign issuers as well as in securities of companies of any market capitalization, including small and mid cap common and preferred stocks. The Fund may not invest more than 25% of its total assets (valued at the time of investment) in securities of companies engaged principally in any one industry other than the public utilities industry, nor have more than 20% invested in foreign issuers. The Fund will purchase a fixed income security only if, at the time of purchase, it is rated investment grade by at least two nationally recognized statistical rating organizations.

DNP Performance

DNP recently held 139 position, and it benchmarks itself to a composite index of both stocks (i.e. the S&P 500 Utilities Index) and Utility Bonds (i.e. the Bloomberg U.S. Utility Bond Index). You can see in the table below, performance has been roughly in line with the composite index over time.

The above chart (from the annual report) is just over 1-year old, and it looks similar (but slightly different) when taken from this year.

Leverage:

Perhaps concerning to some investors, DNP has performed similar to its benchmark over time, despite the fact that the fund uses a significant amount of leverage (or borrowed money) to magnify its income and total returns. Specifically, DNP recently had approximately 26.8% leverage. According to DNP's annual report, it recently achieved its leverage as follows:

As of April 30, 2022, the Fund had $1.105 billion of total leverage outstanding, which consisted of: (i) $75 million of floating rate preferred stock, (ii) $132 million of fixed rate preferred stock, (iii) $300 million of fixed rate secured notes and (iv) $598 million of floating rate secured debt outstanding under a committed loan facility. On that date the total amount of leverage represented approximately 25% of the Fund's total assets.

Leverage can help returns in the good times, but can hurt returns in the bad times (for example, when bond prices are falling, like they have been over the last year as the fed raised rates).

Steady Monthly Income

Despite share price volatility, DNP has continued to deliver steady monthly distribution payments to investors, as you can see in the following chart.

This steady monthly income is why many people own DNP, however there are a few things you should know. For starters, the distribution doesn't come 100% from dividends or interest payments on the underlying stocks and bonds that it holds (we wouldn't expect this either). Rather, some income comes from capital gains and return of capital ("ROC"), as you can see in the following table.

Under the terms of the DNP's Managed Distribution Plan:

The Fund seeks to maintain a consistent distribution level that may be paid in part or in full from net investment income, realized capital gains, and a return of capital, or a combination thereof. The Fund is permitted to distribute more than its income and capital gains; therefore, a portion of your distribution may be a return capital. A return of capital could occur, for example, when some or all of the money that you invested in the Fund is paid back to you. A return of capital distribution does not necessarily reflect the Fund's investment performance and should not be confused with "yield" or "income."

A little ROC is fine periodically (to keep the distribution big and steady), but too much ROC over time can create challenges in terms of maintaining the distribution. We're comfortable with DNP's recent ROC (especially considering the historically rapid pace of interest rate hikes) and its ability to maintain its NAV over time.

Distribution Reinvestment ("DRIP") Program.

DNP has an attractive program in place to allow investors to reinvest their distributions back into the fund at a competitive rate (especially considering the shares currently trade at a large premium). Here is how DNP describes it in their fund fact brochure .

How Reinvestments are Made By participating in the plan, you authorize the Agent to reinvest all of your cash distributions in additional common shares. The total number of reinvestment shares will be allocated among you and the other plan participants on a pro rata basis, and will be determined by dividing the dollar amount of the distribution to be reinvested by the applicable price per share, determined as follows:

(a) If the current market price of the shares equals or exceeds their net asset value, the Fund will issue new shares to the plan at the greater of current net asset value or 95% of the then current market price, without any per share fees (or equivalent purchase costs).

(b) If the current market price of the shares is less than their net asset value, the Agent will receive the distributions in cash and will purchase the reinvestment shares in the open market or in private purchases for the participants' accounts.

Each participant will pay a per share fee, (or equivalent purchase costs) incurred in connection with such purchases. Purchases are made through a broker selected by the Agent that may be an affiliate of the Agent.

And this works well right now, because the fund trades at a significant price premium to NAV, as we describe below.

Premium to NAV:

DNP currently trades in the market at a significant price premium to its NAV (~22.9% as you can see in the graph below), and the fund addresses this through its distribution reinvestment program (as described above). Specifically, if you reinvest your distributions now you get more shares below the current market price (a good thing!).

Specifically, the DRIP currently gives you more shares at 95% of the market price, so you're still paying above NAV, but less than the current market price. DNP issues these shares new, so in theory they are constructing them by buying mores stock and bond shares for the fund in the open market, so all shareholders benefit.

Fund Expenses:

Per the fund's annual report, DNP's gross expense ratio was recently 1.9%, and excluding the cost of leverage, the expense ratio would have been 0.98%. These fees absolutely detract from your bottom line income and total returns, however they are fairly typical for a closed-end fund.

Interestingly, the fund has performed fairly consistently with its benchmark over time, despite the leverage ratio (which might lead you to believe it should outperform over time considering the market has gone up-DNP should have gone up more). But if you are simply looking for the type of steady income you would expect from utility stocks and investment grade bonds, DNP has not been terrible.

Conclusion:

So who should invest in DNP? If you are looking for the type of steady income you would expect from utility stocks (utility stocks generally have less volatility and higher dividend income than other stocks) and investment grade bonds (generally safer than junk bonds), DNP is worth considering. Despite the leverage (which adds risk and expenses), and despite the big price premium (which is a risk because there is no guarantee the premium won't disappear-which would hurt the value of current DNP investors), DNP has performed reasonably well, and has continued to provide the monthly income that a lot of investors want.

We don't currently own shares of DNP (you can view our new ranking of Top 10 Big-Yield CEFs, here ), but it is on our watch list (for our Blue Harbinger "High Income NOW" portfolio), and we wouldn't fault anyone too much for owing it (even though it does trade at a very large premium to its NAV).

Above all else, be sure to invest only in opportunities that are consistent with your own personal investment goals and situation. Disciplined goal-focused long-term investing continues to be a winning strategy.

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