UTG - UTG: I'm Buying This Monthly Paying Utilities Fund

Summary

• Reaves Utility Income is a premier monthly paying CEF with a 7.5% yield.
• The fund has never cut its monthly payout, has raised it 12 times since inception, and does not use the return of capital.
• Management has expressed confidence in the ability of the fund to continue to perform well against current financial volatility.

I'm buying Reaves Utility Income ( UTG ) on the back of its 7.5% yield paid monthly and its portfolio of broadly recession-resistant utilities. The closed-end fund provides diversification for my income portfolio heavy in REITs, BDCs, and preferreds. There's a lot to like about utilities too with these forming a low-risk industry with broadly investor-friendly regulated returns and with a secular growth demand driver from decarbonization.

The fund holds Ameren ( AEE ), NextEra ( NEE ), and Duke Energy ( DUK ) amongst its top 10 holdings which collectively constitute just under 44% of its total portfolio. The monthly payouts are free from return of capital ((ROC)) and have been maintained on an upward trajectory since inception. To be clear, the CEF has not only never cut its dividend since it started trading in 2004, but it has also raised it 12 times since this date at a compound annual growth rate of 5.47% from inception to 2022.

Further, comments from Tim Porter, UTG's portfolio manager, that the CEF should continue to "generate stable and growing dividend income" for its investors regardless of the financial market volatility provides another layer of certainty and confidence in a UTG position going into what could be a recession later this year.

A Window Into The Fund

Whilst the CEF also holds some non-utility companies like Union Pacific ( UNP ) and Verizon ( VZ ), roughly two-thirds of the portfolio is invested in utilities. Telecommunications forms the second largest industry exposure at 16.5% with real estate the third largest at 9%. Being heavy on utilities is obviously the main reason I'm in the fund, but broad diversification across a number of other industries will help to reduce the threat of any potential future industry utility-specific black swans.

As per the United Nations, extreme weather events are on the up . My concern on this focuses on the potential of recurring and more extreme events following Hurricane Ian and the impact it could have on future energy infrastructure from power lines to thermal power plants. Indeed, according to S&P Global , many of the most costly natural disasters happened in the last decade and they expect US utilities to focus their mitigation efforts on insurance, infrastructure investments, and managing regulatory risk. Hence, as one-in-100-year weather events become more commonplace, the downstream impact on the valuation and overall earnings profile of US utilities could be negative.

The CEF trades on a relatively marginal 0.43% premium to its net asset value which stood at $30.15 as of the end of Friday last week. This is down on its average three-year premium of 1.23%. One of the long-term value opportunities from the $2.17 billion CEF comes from its exposure to companies that stand to drive significant capital growth over the next decade.

Bringing Energy To Life

NextEra Energy, which currently forms 4.58% of the CEF, is a clean energy behemoth and is the largest generator of renewable energy in the world. The company also has a rapidly growing portfolio of utility-scale storage with plans to build at least 8 GW of battery storage capacity over the next few years. NextEra is planning to spend $85 billion to $95 billion on capital investments between 2022 and 2025.

At the crux of this growth expected not just for NextEra but Duke Energy and the broader portfolio of utilities is the $370 billion Inflation Reduction Act. This is the single largest action ever taken by the US to reduce and mitigate the impacts of climate change. Utilities stand to receive significant tax breaks from the IRA from nuclear, solar and wind production tax credits to a 30% storage investment tax credit. A material amount of money is expected to be invested in decarbonization over the next decade to drive the next phase of growth for utilities. Hence, the broader macro growth story here is attractive and renders UTG a core long-term income holding. Returns for utilities are regulated by Public Utility Commissions which set a certain level of allowable return on equity.

In the US, the average ROE for utilities stands at around 10.13%. Hence, every capex dollar results in around 10.2% of ROE. This is why such significant moves by US policymakers to decarbonize the grid will prove to be such a huge driver of growth for utilities over the next decade.

Bears might point to the large per cent of distribution that was derived from long-term capital gain, these are the net gains realized from the sale of securities. However, the CEF has made enough capital gains to be able to meet the income expectation of its shareholders without leaning on ROC. The real risk is whether this can continue against expected market volatility. But with the distribution being maintained through the 2008 crisis and subsequent recession, it's hard not to feel confident in my UTG position. I'm bullish and will continue adding to my position as long as the yield remains above my target 7% rate.

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