2023-09-28 17:59:37 ET
Summary
- Closed-end funds with high distribution rates and elevated premiums may be setting investors up for significant losses.
- Guggenheim Strategic Opportunities Fund (GOF) and Gabelli Utility Trust (GUT) are sell candidates due to weak distribution coverage and massive near all-time high premiums.
- We offer some alternatives that are much better valued and offer similar or even higher distribution yields than these time bombs.
Written by Nick Ackerman, co-produced by Stanford Chemist.
Closed-end funds offer investors the opportunity to exploit discounts and premiums. Sometimes, premiums on funds get too high; these are often driven by higher-than-usual distribution yields that are offered from some funds. Generally speaking, the higher the distribution rate, the more cautious one should be when considering such an investment.
That isn't always the case, but it is a general guideline to give a fund a deeper look. Oftentimes, with a distribution rate that is incredibly elevated with the combination of also having an extremely high premium, it is these funds that are setting investors up for some significant losses.
We aren't talking about the Cornerstone funds, as that is their "thing." They operate with massive distribution rates that reset annually with the idea that they will sell shares regularly, but at the end of the day, you'll still have S&P 500 Index-like returns as time goes on. That game may not last forever, but it's certainly been on a long run and works out quite well for investors who are familiar with how to play the game.
Here are two recent examples of funds that were paying out distributions that were way too high for far too long but were trading at elevated premiums: Brookfield Real Assets Income Fund ( RA ) and Duff & Phelps Utility and Infrastructure Fund ( DPG ). Upon announcing their overdue distribution cuts, the share prices were met with a brisk drop off a cliff.
Today, I wanted to look at two other funds that are sell candidates for investors. I also include additional options that merit further looks by investors as swap candidates.
Sell #1: Guggenheim Strategic Opportunities Fund ( GOF )
GOF is one I had warned of previously of having weak distribution coverage, and combining it with a higher premium was setting it up for potentially deep losses in the future.
In fact, when I last covered its newer sister fund, the Guggenheim Active Allocation Fund ( GUG ), I suggested that GUG could be a great alternative for investors already holding GOF. GOF currently trades at a premium of 25.64%, which it regularly trades at a premium, but even this premium is pushing near all-time highs.
An absolute premium on its own isn't necessarily cause for immediate panic. Instead, I would be more worried about seeing what we saw happen with RA and DPG previously when they cut their distribution because I believe it is at risk. The biggest defense on this is that the fund has never cut before, so they won't now.
And well, there is some truth to that. CEFs can pay out what they'd like for as long as they'd like until NAV reaches $0. However, eventually, the fund will get to a point before that happens when they do the inevitable and slash the payout to stop the bleeding.
In this case, GOF's distribution rate on the NAV is pushing a stratospheric level of 18.13%. That on its own should be considered a red flag where some skepticism should start. If we look at its annual report, we will see a worrying trend of lower and lower net investment income being generated as well.
The annualized payout comes to $2.1852, and at NII of $0.75, this primarily fixed-income fund's payout coverage comes to just 34.3%. Higher interest rates have pressured their borrowing costs, and that's a big driver of it.
However, with such a lack of coverage already, that is another factor. The underlying portfolio has been bleeding assets over the past five years, and the fund's NAV per share continues to get smaller and smaller. At some point, a cut will be needed, or the fund will start to erode faster and faster as it becomes even more difficult to cover the payout.
Since that GUG article, GOF has slightly outperformed GUG, but the actual total share price results have been the exact same. GOF briefly continued to outperform - which was really pushing further into premium territory. So, it wasn't actually 'real' portfolio performance driving it.
If one wants a slightly different fund but wants a high distribution rate at a more reasonable price and one that is being fully covered right now, then XAI Octagon Floating Rate & Alternative Income Term Trust ( XFLT ) could also be a consideration for investors. In the last year, XFLT had also blown away in terms of total returns, but we can see it isn't nearly as closely correlated as GUG and GOF are, which makes sense, being from the same family with a similar strategy.
GUG and XFLT offer much better valuations. GUG is at a massive discount, and XFLT is at a more reasonable premium relative to GOF.
GUG offers a lower distribution rate of 10.39%, which is juiced up from its NAV rate of 9.01% due to the massive discount. Distribution coverage there looks a bit better at almost 56%. That still isn't great, but due to such a sizeable discount already, if there was any distribution cut, then the result would be generally less damaging in terms of a widening discount.
XFLT, on the other hand, while being positioned significantly differently, can afford a 14.55% distribution yield currently. The distribution coverage based on NII came to 108% as of their last semi-annual report. However, they have since upped their distribution because they had room to increase it.
Sell #2: Gabelli Utility Trust ( GUT )
One other fund I want to dunk on a bit here is GUT. I have never covered GUT because there is no reason even to consider this fund a viable investment option in the CEF space.
The fund sports a 121%+ premium to its NAV. An absurd premium is fairly standard for this fund, but we are getting to a level now where I have no possible clue what investors are thinking. This fund is set up to hit investors with some catastrophic losses.
This one isn't even a fund that has never cut its distribution. They had previously shortly after the global financial crisis. At an NAV distribution rate of 20.27%, we are at an asinine payout that is completely unsustainable, and that's not even presenting the fact that utilities are performing terribly this year.
You see, as this is an equity fund, they will require a substantial amount of capital gains to fund their payout. That isn't anything new, but with utilities being the worst-performing sector this year with rates still expected to be elevated for the next year, there doesn't seem like a strong chance that utilities will be booming back anytime soon. That translates into continued pressure for GUT's distribution that won't seem to be reversed anytime soon, either.
Here is where I get even more dumbfounded with GUT; due to the massive premium on the fund, the distribution rate comes to 9.15% for shareholders. The fund has to earn over double what investors would be paid out. At the same time, there are plenty of other utility-focused CEFs that offer even better distribution yields and are much safer. In fact, I'd go back to DPG here and say that's a much better fund to consider at this time.
Over the last three years, the fund's performance had been virtually the same on a total NAV return basis. I use the last three years because DPG was a more global-oriented fund previously but had changed at the end of 2019. We discussed DPG more in-depth in recent coverage .
DPG sports a 9.55% distribution rate even after their cut, which is higher than what an investor receives with GUT. On an NAV basis, it's a much more manageable ~8% rate.
Even if you didn't want to invest in DPG due to the quarterly distribution, the Cohen & Steers Infrastructure Fund ( UTF ) or Reaves Utility Income Fund ( UTG ) are both additional options worth considering.
Over the last decade, they even performed better than GUT in terms of total return. Even if you don't like total returns and just want yield, UTF offers a 9.05% distribution rate with a fairly reasonable 8.62% distribution rate on the NAV.
For UTG, you'd look at a distribution rate of 8.85% - it's lower than GUT, but certainly not by much for the risk one is taking with investing in GUT. On a NAV basis, it comes out to a similar 8.84% due to trading at near parity with its NAV.
UTF and UTG don't necessarily offer the best entry discounts for starting an initial position but are much more reasonable than GUT.
Admittedly though, some of this premium is being corrected already with today's moves. Utilities are getting slammed due to softer guidance from NextEra Energy ( NEE ) and NextEra Energy Partners ( NEP ). NEP, in particular, slashed their guidance .
If we looked at it another way, let's say these funds cut their distributions and go to a 15% discount - which is exactly where RA and DPG have now been floating after their cuts. For UTG, we'd see a loss of -14.87% for investors. UTF would see investors lose -10.74%. For GUT, investors under this scenario could imagine a loss of -61.65%. These losses come swiftly, too; generally, the big drop is the first day, and then a drift lower can happen for the following weeks.
Conclusion
High premiums with unsustainably high distribution yields don't mix. We've seen plenty of examples of significant losses stemming from this toxic combo. GOF and GUT are set up for significant losses going forward. How long will it take? That's impossible to know. However, these are like ticking time bombs if you are holding either in your portfolio. Investors have the opportunity to swap to better candidates that can offer potentially more sustainable distributions at similar or even higher yields.
For further details see:
2 CEFs To Sell (GOF And GUT) With Better Replacements