UTG - UTG Shows The Bind Utilities Are In

2023-08-07 05:01:02 ET

Summary

• Reaves Utility Income Trust aims to provide high levels of after-tax total return through dividend income and capital appreciation.
• UTG has underperformed in terms of price appreciation but has yielded positive total returns over the past five years.
• We think that constituent companies will find it difficult to out-earn their cost of capital in a rising interest rate environment.

Background

Indexing serves many purposes--the first use is to gain a quick view of a broad market or individual sector at the highest level, while in later years investors divined them as useful in gaining investment exposure to a broad swath of companies without being disproportionately impacted by the problems or successes of any individual company. At the bottom, investing in a fund which focuses on a particular sector is a useful way to express a market opinion without having to pick individual winners and losers.

Some sectors are more useful for certain things than others, generally. While a technology sector fund might be good for growth, investing in a utility fund is typically thought of as a way to generate income through dividends. On that note, today we're discussing the Reaves Utility Income Trust ( UTG ) and what investors should make of it today.

Let's dive in.

The Fund

UTG is a closed-end that invests principally in utilities with the intent of distributing income to investors. The fund fact sheet (accessed August 4th, 2023), states that:

The investment objective of the Fund is to provide a high level of after-tax total return consisting primarily of tax-advantaged dividend income and capital appreciation. It intends to invest at least 80% of its total assets in dividend-paying common and preferred stocks and debt instruments of companies within the utility industry.

On a price appreciation basis, UTG hasn't kept up with the broader market overall, though this isn't exactly surprising given the industry of the fund and the aim of providing income.

Over the past five years the stock has returned negative 11% to shareholders on a price appreciation basis alone. Total return figures (which assume reinvestment of dividends) are quite better, yielding 25% over the same period.

Being a closed-end fund, it's important for investors to note that unlike open-end funds, UTG does not issue new shares when investors buy or sell them on the market. This enables UTG to trade at a discount or premium to its net asset value [NAV], which is the cumulative value of its holdings expressed as a share price. Per the latest information available on the fund website , UTG currently trades at a 1.22% premium to its NAV.

The Investments

Now that we've covered some of the basics regarding how the fund works, we'll dive into the fund's holdings and their fundamentals.

As of this writing UTG has an indicated yield of 8.3%--quite attractive, especially when compared to dividends available in individual blue chip stocks and the fact that the current two year treasury yields 4.88% .

Dividends are nice, of course, but where the dividends come from is also important to know. For individual companies, it's important to know whether cash from operations is greater than dividend obligations, otherwise the company's dividend may be unsustainable. For funds, understanding whether dividends are being passed directly through to investors from the held companies versus capital gains distributions is the main focus.

Looking back to 2004 UTG's dividend payment mix reveals a bit of a concerning trend. While up until 2014 the lion's share of dividends were paid via qualified dividends, in 2015 the mix began to shift significantly towards the distributions of long term capital gains.

This is critical for investors to watch, because distributions of capital gains means that the fund is selling off positions in which it has unrealized gains--essentially, selling its winners.

On principle, this is a trend that investors should be wary of, as a declining amount of dividends versus a growing level of capital gain distributions could be a signal of coming troubles.

Additionally, utilities in general have struggled in the face of higher interest rates. This is something of a function of the utility industry itself--utilities are capital intensive businesses that regularly rely on the issuance of bonds to fund expansions and maintenance. Bonds, of course, are easy enough to issue, but issues arise for utility companies when it comes time to come up with the cash to pay those bonds since the vast majority of utilities do not possess pricing power. Instead, utilities must generally lobby for rate increases in the communities they serve (you can imagine how popular that is), and hope that the voters (whoever they may be) approve.

A rising interest rate environment has hurt utilities in other ways as well.

Above is a chart depicting the return on capital for UTG's top five utility holdings, the highest of which is 4.2% and the lowest 3.7%. This figure is especially important in the face of rising interest rates.

Remembering again that the two year treasury rate is currently 4.88% implies that utilities would have a difficult time (to say the least) issuing bonds below this amount. In general, companies that cannot earn a return on capital greater than their corresponding cost of capital are in for a tough ride unless something changes. Utilities, it seems, are in particularly difficult bind at the moment.

The Bottom Line

While UTG has issued a steady dividend for many years, we are concerned that a majority of the dividend payout in recent years has come from capital gains. While this could always reverse, it is something we think investors should be aware of. Additionally, the constrained nature of utilities in particular at the moment gives us pause, since they generally do not have unilateral pricing power but must routinely turn to capital markets to finance operations as discussed above.

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