2023-10-09 01:49:20 ET
Summary
- Duff & Phelps Utility and Infrastructure Fund discount has expanded rapidly after their distribution cut earlier in the year.
- The discount on DPG's shares seems to be stabilizing as there are signs the dust is beginning to settle, offering the potential for better results in the future.
- Utilities are facing pressure from rising interest rates and inflation, which could impact their ability to sustain distributions even at the new lower rate.
Written by Nick Ackerman, co-produced by Stanford Chemist.
Earlier this year, Duff & Phelps Utility and Infrastructure Fund ( DPG ) announced to its investors a big whack to the distribution. They cut their payout a whopping 40%, taking it from $0.35 to $0.21 per quarter. This had been on the back of continuing pressure from rising costs on their leverage and the fact that utility performance has been far from spectacular.
Today, the dust seems to be at least getting close to settled on DPG, as there are some signs of bottoming for the discount. Combine that with the significant pressure on utilities overall, and investors could be set up for much better results going forward than what they've historically received.
The Basics
- 1-Year Z-score: -1.84
- Discount: -15.22%
- Distribution Yield: 10.29%
- Expense Ratio: 1.62%
- Leverage: 30.35%
- Managed Assets: $535.3 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."
Utilities Continue To be Pressured, But Distribution Cut Dust Seems To Be Settling
As noted, utilities haven't been great performers this year after holding up relatively well, heading through 2022's tech-driven bear market. In fact, utilities continued to get bogged down by the risk-free rate heading higher. Utilities are the worst performing sector this year, but far - followed by real estate. The latest projections from the Fed are now looking at fewer cuts than originally expected heading through 2024. It's these continued projections of higher for even longer that put pressure on these income-oriented investments.
Not only do utilities compete with investor dollars against risk-free rates for income-driven investors, but the intensive infrastructure business takes lots of debt to fund new projects and maintain old ones. Rising costs on the back of higher inflation will see CAPEX and interest expenses running higher and further pressuring shares of these infrastructure/utility companies.
All of that being said, it isn't necessarily all doom and gloom. Most assuredly, the sun will rise again tomorrow, and consumers will still want to use electricity and natural gas. That's what makes these sorts of companies cash flow machines that return capital back to shareholders - even if they aren't the most exciting investments in terms of growth.
Going back specifically to DPG, the Fund's discount seems to be bottoming out near this 15% discount level. Even despite last week's pressures of seeing the Fund's NAV taking around a ~6% haircut on the back of the utility sell-off as interest rates surged.
Historically speaking, this is a level where the Fund has previously bottomed out. However, the exception to that was the Covid-induced market sell-off. That's not all that unusual, though, as we'd seen outlandishly freakish discounts during that period from most other CEFs as well.
If anything was out of the ordinary, it was the Fund's premium in the last several years that was the unusual event. But all good things must come to an end eventually, and it's a story we've seen play out several times over.
In fact, DPG seemed to really be the one to get this party started. Since then, we've also seen other noteworthy cuts: Brookfield Real Assets Income Fund ( RA ) and John Hancock Premium Dividend Fund ( PDT ) to name a couple that were trading at fairly rich valuations. That said, even with Virtus Total Return Fund ( ZTR ) and John Hancock Hedged Equity & Income Fund ( HEQ ) being at fairly substantial discounts, they still saw a material drop further into discount territory.
It was simply that DPG and RA were the most egregiously overpriced, with unsustainable distributions relative to the others.
Is The New Distribution Sustainable?
This is another tough question made only more complicated in the CEF wrapper.
First, we don't know what is going to happen in the future. We could have a black swan event happen tomorrow, and rates get cut immediately. And while a black swan event would most likely cause immediate damage in terms of drops in share prices, the headwinds of interest rates could mean better performance going forward. Alternatively, suppose inflation remains higher and the Fed has to continue to hike their projections to rates higher for even longer. In that case, these funds will face even more pressure - and thus, forward distribution coverage would be questionable.
Second, closed-end funds can really pay whatever they'd like for as long as they'd like - whether it is being earned or not. Case in point, DPG has historically not covered its distribution due to the rather lackluster historical performance. This was even prior to when the Fed began ramping up rates, and we covered the Fund in early 2022 . It was a more global-oriented fund, and it changed its investment policies and name around a bit to potentially perform better going forward (hindsight shows that didn't play out at this point.)
The NAV distribution rate of 8.90% for the fund isn't anything too outrageous either. After the recent cut, I'd suspect they would maintain their distribution at current levels for a reasonable period of time. With that taken into consideration, it depends more on one's own outlook going forward:
- Do utilities recover, and they can produce capital gains to fund their distribution? Then, yes, it could be seen as sustainable.
- Do utilities remain pressured due to higher for even longer rates pressuring the underlying portfolio? Then, expect continued pressure on DPG's portfolio and its ability to support the current distribution.
As we noted in our previous update after the big cut, their semi-annual report shows that they don't earn any positive net investment income anymore after the rising rates have increased their borrowing costs.
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.
DPG's Portfolio
At this point, it looks like we are seeing a dated fact sheet and semi-annual report in terms of the portfolio positioning. All the data is from April 30, 2023. That being said, the portfolio hasn't historically changed too dramatically in the last couple of years between reporting periods. It remains dominated by the utility sector exposure, followed by midstreams. Additionally, it is an update from the January 31, 2023 data we had to go off in our prior update.
The energy sector and utility combo last year made the Fund perform relatively well compared to the broader market as measured by the S&P 500. DPG was essentially flat on a total NAV return basis in 2022. However, as we saw, utilities are the worst-performing sector this year, and energy hasn't provided any meaningful reprieve as it is essentially flat this year.
The larger weighting to U.S. investments and inclusion of broader infrastructure allocations in recent years came about as part of the 2019 rename and investment policy change.
Despite fairly active management with a turnover rate of around 50% in the previous 5 years, several of the top names have remained fairly consistent with the listing we had covered in an earlier update showing the holdings from last October.
Overall, this Fund has a rather narrowly focused portfolio when compared to some of its peers who hold hundreds of different positions. In total, DPG has around 40 positions. With NextEra Energy ( NEE ) being a particularly weak performer lately as it announced its yieldco, NextEra Energy Partners ( NEP ) would have a much softer outlook. This led to a drop in the overall utility space as well as interest rates climbing to highs not seen since 2007.
Conclusion
DPG has continued to face pressure since our last update , but I believe that the dust is starting to settle in terms of the funds discount. However, interest rates could continue to play a role in driving down the value of its underlying portfolio.
With DPG's discount appearing to find a bottom and utilities being at a better valuation after rate pressures, the results for DPG could be much better going forward than we've seen historically.
In the past, DPG was one of the weaker performing utility funds, but at the right discount and a bit of a differently oriented portfolio, it can still make sense to own it today. At the very least, it's looking like a much better bargain now than it was prior to the cut. However, I don't suspect we will see the Fund's premium return to where it was previously for a considerable period of time, if ever.
For further details see:
DPG: Worth A Look As The Dust Settles