GUT - GUT: The Premium That Refuses To Die

2023-12-14 07:54:08 ET

Summary

• The utilities sector faced a tough year in 2023, contrary to its usual defensive nature during economic downturns.
• GUT displays an extremely high premium to its net asset value (NAV), currently at 109.3%. This high premium remains despite changes in the utilities sector and interest rate landscape.
• Rising treasury yields offer returns above 5%, making investments in utilities or high-premium CEFs like GUT less appealing compared to alternative options.
• There's a substantial risk for investors if the fund were to liquidate suddenly, potentially leading to significant losses due to the unsustainability of the current premium.
• The fund is utilizing a high amount of ROC, and its NAV has been steadily decreasing.

Thesis

Gabelli Utility Trust (GUT) is an equities closed end fund. We covered the name at the beginning of the year, when we put into balance the fund's high premium with the market's propensity to migrate towards defensives in a risk-off environment. Given the peak in rates and recent drawdown in the utilities sector, we are going to revisit the name to establish whether this CEF is a palatable option for new money entering the space and whether existing shareholders should continue to hold the name. Interest rates have changed dramatically since the start of the year, and the palatability of GUT as a holding has changed as well.

Utilities have had a tough 2023

2023 has been a tough year for any 'bond-like' investment:

The Utilities Select Sector SPDR ETF ( XLU ) is down -7.33% on the year, with a significant drawdown that experienced an extreme point in October. Surprisingly, GUT has outperformed another CEF we cover, namely DNP Select Income Fund ( DNP ), a golden standard in the space.

The utilities sector is known as a defensive one, with high yields attracting conservative investors who favor safety over capital gains. Utilities have historically traded at yields of 100 bps over 10-year treasuries, which explains their resilience through non-inflationary recessions. This year has been different, with the massive spike in rates driving a re-pricing across the sector:

Utilities have not had a negative total return year since 2015, with 2022 slightly positive on the back of a risk-off environment.

The premium that refuses to die

GUT is an astounding CEF that sports a premium to NAV in excess of 100%:

We can see the fund currently trading at a 109.3% premium to NAV, close to the high end of the range. Just so that readers correctly understand this figure, let us spell this out for them: if the fund liquidates tomorrow, as an investor you will get $2.91/share (i.e. the current NAV), versus the current market price of $6.03/share. That is 50 cents on the dollar in terms of recovery.

High premiums to NAV usually occur during low rates environments, when investors flock to CEFs and bid up price levels. During periods of high interest rates (like today's), and especially during periods of turmoil for the underlying asset class, one should see the premiums to NAV deflate. And we have seen this occur in the REIT CEF asset class and in the buy-write CEF asset class.

Not for GUT though, which is shocking. The fund did have a massive move in the premium from 120% to almost 80%, but has retraced part of that recently.

As a retail investor, one needs to understand that when a premium to NAV is this high, the CEF's returns are no longer driven by the underlying asset class (i.e. utilities), but by other investors' perception of the fund. If one or two large holders decide to sell and the premium to NAV collapses, it can trigger a waterfall effect, even if utilities do not move from a price standpoint. At this stage of pricing, GUT resembles bitcoin to a certain degree because its primary risk factor is other people's desire to buy into the name rather than fundamental cash-flow and profitability analysis for the underlying companies.

When opportunities abound, you do not need to gamble

The one item that has changed tremendously since the start of 2023 is the set of opportunities present for investors. With the significant rise in rates, retail investors can achieve yields in excess of 5.2% in treasuries, and yields in excess of 6.1% from short-dated, low-duration bond funds, a number of which we have covered:

• VRIG: Could Keep Delivering A 6.3% Yield Well Into 2024
• FLRN: Floating Rate Investment Grade Bonds, 6.06% Yield

If an investor is set on taking a view on utilities, they can buy them outright via an ETF like XLU or DNP or UTG in the CEF space. The number one rule for a CEF, given its structure, is to buy a low discount and sell a high premium. The market offers opportunities in utilities CEFs with normalized premiums when looking at their z-scores.

Will GUT actually liquidate and incur a 50% loss for current investors?

We outlined above how a sudden liquidation or conversion of the CEF would incur a rough -50% loss for current investors. Even though the math looks bad, the probability of a liquidation occurring is low. CEF structures exist because they generate sizable fees for the asset managers running the management companies. Unless the collateral pool shrinks to under $50 million, we are hard-pressed to see this CEF liquidating.

The low probability of liquidation should not put existing investors at ease, though. Even if utilities as an asset class remain flat, GUT can still generate a substantial loss if money flows suddenly shift from this CEF. There is no reason to be in this fund at the current time in our opinion. The downside is huge, while the upside is extremely limited. We are of the strong opinion that existing shareholders should capitalize on the current large premium by existing the name, eying a more normalized premium (lower than 20%) to re-enter.

The high premium hides an ugly truth

Despite its stated 9.8% dividend yield, the CEF's performance does not support it:

The CEF's NAV tells us the classic story of overdistribution, where on long time frames we have an ever-decreasing net asset value. Robust funds will have a fairly stable NAV over a decade, with dips during recessionary times. Not here. The NAV performance is a down-facing arrow, telling the story of continuous value erosion.

We can see the fund's high usage of return of capital via their latest annual report :

In 2022 over 80% of the fund's distributions ended up being characterized as return of capital.

Conclusion

GUT is an equities CEF. The fund focuses on utilities, and trades at an astounding 109% premium to NAV. With 2023 being a very rough year for the utilities asset class we would have expected a deflation in said premium to NAV. However, it has not happened yet, despite the CEF's NAV being a mere 50 cents/dollar when compared to the current fund market price. Mean reversion will eventually occur, and we fear it will be a violent and sudden affair.

There is nothing to like about GUT currently. The fund has an unsupported dividend yield, an ever-decreasing NAV, and a high return of capital utilization. New money should stay away from this name, while existing shareholders should exit as well in our opinion, with the upside in the name being negligible when compared to the downside. The market is currently offering plenty of true high yielding opportunities, with even safe assets yielding in excess of 5% as highlighted in the article. We would only revisit this name when the premium goes below 20%. We are a Sell until that point.

For further details see: