DPG - DPG: The Big Cut

2023-07-02 20:42:04 ET

Summary

• Duff & Phelps Utility and Infrastructure Fund investors experienced a significant distribution cut, causing shares of DPG to fall substantially.
• The cut was due to increased leverage expenses and overall market conditions, making the previous distribution level unsustainable.
• Despite the cut, the fund's distribution rate remains attractive at 8.3%, and the fund is now trading at a discount, making it more interesting for investors.

Written by Nick Ackerman, co-produced by Stanford Chemist. A version of this article was originally published to members of the CEF/ETF Income Laboratory on June 18th, 2023.

Duff & Phelps Utility and Infrastructure Fund ( DPG ) investors got a big distribution cut that was quite shocking. The distribution coverage wasn't strong, and the distribution level was elevated. However, that has been the case for a while, and they continued to pay out this elevated level regardless. The actual size of the cut was also quite dramatic at a 40% decrease , which was more the main shock, in my opinion.

This resulted in shares of DPG falling substantially. This is one of the main problems with funds that trade at high premiums and pay out elevated and unsustainable yields. We've highlighted this several times in the past, which was why I could never see owning this fund due to these two factors.

However, after this cut and big plunge in the price back down to a discount, it's a much more interesting fund today. It continued to trade even lower after the initial drop too.

The Basics

• 1-Year Z-score: -3.68
• Discount: -12.18%
• Distribution Yield: 8.63%
• Expense Ratio: 1.62%
• Leverage: 31.32%
• Managed Assets: $662 million
• Structure: Perpetual

The investment objective for DPG is "to seek total return, resulting primarily from (i) a high level of current income, with an emphasis on providing tax-advantaged dividend income, and (ii) growth in current income, and secondarily from capital appreciation."

They intend to meet this objective by "investing primarily in equities of domestic and foreign utilities and infrastructure providers. The Fund's investment strategies endeavor to take advantage of the income and growth characteristics of equities in these industries."

The Big Cut

The distribution cut took the quarterly payout from $0.35 per share to $0.21. They had previously no cuts since their inception going back to 2011. The reasoning provided by the fund was that leverage expenses have been climbing, which will impact expected earnings, which is true.

At its June meeting, the Board of Directors voted to maintain the Fund’s Managed Distribution Plan, but to decrease the quarterly distribution rate from its previous level of $0.35 per share to a new level of $0.21 per share. This represents a decrease in the annual distribution level from $1.40 per share to $0.84 per share. The 40% decrease in the distribution reflects the increase in the Fund’s cost of leverage, current and expected earnings, and overall market conditions. The Fund’s investment adviser and Board of Directors believe that the new distribution level should be more sustainable over time and thus that the new level is in the long-term interest of shareholders.

This is exactly the problem most leveraged funds are dealing with right now. We also noted this in our previous article .

NII coverage came to 8.25%, and we know that with higher leverage costs, this should go down going forward. The decline could be negated to some degree by higher dividends in the portfolio, as most utility companies raise their dividends annually.

Mix in that the fund's distribution rate was already pretty high at nearly 12.5% pre-cut, and that's going to make it even more unsustainable than it already was.

In my previous article, I noted that the distribution rate was elevated. At that time, it was around 11.5%, so it's only become worse since then. However, I didn't exactly expect a cut, either. The reason is that they were paying out at an unsustainable level previously, and Duff & Phelps has shown resiliency to cut their payouts.

With that being said, CEFs can pay out what they want for as long as they want until NAV goes to $0. In this case, the fund's distribution rate comes to 10.25%. That's certainly attractive, but with a hefty premium, the NAV rate is actually 11.43%. That's how much the fund has to earn to cover its distribution.

That alone, we know, is an elevated level relative to what one might be able to expect over the longer term. Despite that, Duff & Phelps, if DNP is any indication, isn't into cutting their distributions.

Their other fund, DNP Select Income Fund's ( DNP ) claim to fame, is the closed-end fund with the longest streak of no distribution cuts. Of course, they are also experiencing higher leverage expenses and facing the same tough environment. They also carry a big premium, so they could be a victim in the future of a big slash, but at this point, the distribution rate on NAV is still sub-10 %. So I feel they will be more focused on maintaining that fund's payout due to its much longer history and not quite too unsustainable distribution.

Regardless, my expectation for DPG to maintain their distribution despite being too high was wrong. However, that is one thing we continually caution against when discussing CEFs that come with the combination of a higher-than-usual distribution yield mixed with a high premium.

What made this even worse is that DPG never really commanded a high premium, like its sister fund. It was more in the last few years that investors warmed up to this fund. This likely meant that the floor was and turned out to be much lower.

So while the 1-year z-score is screaming this is a bargain in the CEF space, its decade-long average is saying this is quite normal if we look beyond the last couple of years - especially given the difficult interest rate environment.

And difficult it is. In our previous article, I noted the fund's NII coverage at around 8.25%. The latest semi-annual report shows us that the fund now generates no NII at all for investors. Capital gains were an important part of the fund's distribution previously, but now it is entirely what the fund needs to cover the distributions to investors and its operating expenses. On a per-share basis, this went from $0.12 in fiscal 2022 to ($0.03) in the last six-month report.

To look at this another way, the fund's total expense ratio went from 2.51% to 3.87%. This will continue to climb as more rate increases get worked through into the fund's borrowing costs.

A more recent development since their last report was on June 12th, 2023, they announced that they were partially redeeming some of their Mandatory Redeemable Preferred Series C shares; these were floating rate preferred. They are doing this to keep their leverage levels in check.

This partial redemption is being made at this time at the Fund’s voluntary option and as part of what the Fund’s investment adviser believes is prudent management of the Fund’s use of leverage. The partial redemption of the Series C MRP Shares is being funded by cash on hand.

The MRPS is paying at a 3-month SOFR plus 2.21%. That pushed their rate in the last report up to 7.10% - which would have now inched up further to 7.16% based on the last reported SOFR . This deleveraging is actually a positive as they know they aren't going to be able to cover the costs of borrowing plus the regular operating expenses.

These preferred represent only a minor portion of the fund's borrowings. They listed another $135 million in the form of secured borrowings. Those are a bit cheaper as that gets charged at a daily SOFR plus a spread. They don't specify the spread exactly, but given what they provided for their preferred borrowings, we can assume it is around 0.85%. That's also in line with what we see from most other CEFs.

In the grand scheme of things, DPG's deleveraging efforts are essentially meaningless because it's taking their leverage down by merely $5 million. That won't move the needle against a portfolio of over $620 million in assets.

However, it's also a negative if assets rebound; they'll have less to rebound with. This highlights the plight that unhedged leveraged CEFs are in. It quite literally makes sense to deleverage entirely. If we look at the costs of borrowings, most of these funds are not gaining any benefit from the leverage being employed with rates where they are. On the other hand, when the rebound comes, it also means less to rebound with and reduced capital gains potential.

Unfortunately, the underlying portfolio of utility and infrastructure holdings is generally more stable and recession resistant. This fund's added leverage and discount/premiums can lead to a bumpier ride anyway.

Conclusion

With the latest distribution cut from DPG, investors were probably in a bit of a shock. Given the distribution coverage, we saw previously and expected weakening coverage in an uncertain environment, it wasn't entirely unexpected to see a cut. However, it was more in the size of the cut that was quite shocking.

I still admit I didn't anticipate a cut, but that's the difficulty in predicting CEF distribution cuts. They can essentially pay out whatever they'd like for as long as they'd like. I felt funds such as Guggenheim Strategic Opportunities Fund (GOF) should have cut their distribution years ago. They're currently running at a 17.72% NAV distribution rate with weak coverage. In the last year, Virtus Total Return Fund ( ZTR ) is another name that I believe should cut its distribution, with its NAV rate pushing over 14% now. Yet, both of these funds continue to declare the same distribution month after month.

That said, for some silver lining, this sizeable cut put the fund in a situation where they don't need to cut for another 12 years moving forward. Additionally, the fund is back at its longer-term average discount. Cutting the fund's distribution down to a current 7.5% NAV rate puts it back into a more sustainable level moving forward. Therefore, when any rebound takes place, they can have more assets to rebound with. The difficult part is knowing when a recovery in the utility and energy space takes place.

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