2023-07-03 23:04:18 ET
Summary
- The Cohen & Steers Infrastructure Fund has been upgraded to a relative buy due to its solid historical performance and corrected sector valuations.
- Despite higher interest rates potentially impacting the fund, the Federal Reserve's end to its rate hiking cycle could ease pressures on long-duration assets like utilities and infrastructure.
- The UTF fund has delivered 10Yr average annual returns of 8.6% and is currently paying a 8.0% forward distribution yield.
I last looked at the Cohen&Steers Infrastructure Fund ( UTF ) in September 2022. At the time, the Federal Reserve was in the midst of raising interest rates and I believed rising interest rates would be a headwind for utilities. Furthermore, utilities were trading at elevated valuation multiples of > 18x Fwd P/E, which meant future returns were likely to be poor. Since my article, the UTF fund has delivered essentially no price return and only 4.7% total returns compared to over 20% returns for the market, justifying my cautious stance (Figure 1).
Figure 1 - UTF has been flat since September (Seeking Alpha)
However, with the passage of time and developments in the macro environment, has my views on the UTF fund changed?
Brief Fund Overview
First, for those not familiar with the fund, the Cohen & Steers Infrastructure Fund is one of the largest closed-end fund on the markets with over $3.1 billion in managed assets and $2.4 billion in net assets. The UTF fund pays a $0.155 monthly distribution that has been maintained for years and charges a 2.19% net expense ratio (Figure 2).
Its focus is on global utilities and other infrastructure assets, with 32.0% of the portfolio invested in electric utilities, 13.5% invested in corporate bonds, 9.5% in midstream energy companies, 7.1% invested in toll roads, and 6.9% invested in freight rail (Figure 3).
Exceptional Long-Term Returns...
I commented on the UTF fund's performance in my prior article, but for a defensively-positioned fund, the UTF has been able to deliver exceptional long-term performance with 10Yr average annual returns of 8.6% (Figure 4).
...Backstopping Generous Distribution Yield
UTF's long-term returns backstops its $0.155 / month distribution, which works out to a forward yield of 8.0% on both market price and NAV.
Since UTF's long-term average annual returns of 8.6% covers its 8.0% distribution yield, I have no concerns about the sustainability of the fund's distribution even though net investment income ("NII") only covers ~1/3 of the annual distribution, as the fund is able to harvest capital gains to fund the rest (Figure 5).
Figure 5 - UTF distributions funded from NII and capital gains (UTF 2022 annual report)
Relative Valuation Turning Attractive
One of the downside risks I highlighted in September was the utility sector's valuation. At the time, utilities were trading at multi-decade highs in valuation multiples, with Fwd P/E > 18x, while the overall market, as measured by the S&P 500, was only trading at ~16x (Figure 6). This was because we were in the depths of the 2022 bear market and investors bid up for the relative safety of utilities.
Figure 6 - Utilities and S&P 500 Fwd P/E (Author created with charts from yardeni.com)
Fast forward to today, utilities' valuation have declined to a Fwd P/E of 17.3x from a combination of earnings growth and stock price declines, while the market's valuation has rebounded to 19.2x.
Although utilities' absolute valuation level of 17.3x is still expensive relative to history, they have gone from 2 P/E multiple turns 'expensive' relative to the market to roughly 2 P/E multiple turns 'cheap' .
End Of Rate Hikes In Sight
The other major headwind I identified in September was the Federal Reserve's interest rate increases. While the Fed was hiking interest rates at a rapid 75 bps per meeting pace in September, the Fed actually paused its interest rate hikes recently in June, and many analysts and traders expect at most one or two additional rate hikes before this hiking cycle is over (Figure 7).
Figure 7 - Most traders expect just 1 or 2 more rate hikes (CME)
The end of the hiking cycle may lessen the pressure on long-duration assets like utilities and infrastructure assets where the revenues and cash flows are far out in the future and are sensitive to increases in discount rates.
Headwinds From Higher Leverage Costs
Unfortunately, part of the damage from higher interest rates may be permanent for the UTF fund. As I highlighted in my prior article, the UTF fund paid an incredibly low 2.7% weighted average cost of debt for its borrowings, as 85% of its borrowings were fixed rate.
However, as of December 31, 2022, the fund had to renew its credit facilities at much higher interest rates of 5.2% on the outstanding $950 million balance. This may be one of the reasons YTD returns for the UTF fund has been sub-par, as it no longer enjoyed the benefit of incredibly cheap debt.
Whether this will have significant negative impacts to future returns remains to be seen, but if interest rates stay 'higher for longer' due to elevated inflation, then leveraged funds like the UTF may continue to see headwinds.
UTF Ranks Well Vs. Peers
Figure 8 shows an updated comparison table against peer utilities-focused closed-end funds.
Figure 8 - UTF ranks well vs. peers (Author created with data from Morningstar and Seeking Alpha)
Overall, the peer group has suffered poor performance in the past year, as the headwinds I identified applied to the whole utility sector and not to a specific fund. The lone outlier is the BlackRock Utility&Infrastructure Trust ( BUI ), which has a more offensive-oriented portfolio allocation and has been able to deliver significantly positive returns in the past year. I wrote about the BUI fund here .
While near-term results have been poor, the UTF fund does rank well compared to the peer group in terms of long-term returns and risk metrics. For investors who are not comfortable with the offensive investments held in the BUI fund, the UTF fund looks like a solid second option.
Risks
The biggest risk to UTF and other utilities-focused funds is if the equity bear market returns. Since utility sector valuations are still expensive on an absolute basis, there may be significant downside if the whole market corrects.
Furthermore, a 'higher for longer' Fed may continue to exert negative headwinds to long-duration assets and leveraged funds.
Conclusion
In summary, I am raising the Cohen & Steers Infrastructure Fund to a relative buy at this time. The UTF fund has a solid historical performance and sector valuations have corrected since I last wrote about them in September.
Overall, utilities have gone from 2 multiple turns 'expensive' relative to the market to 2 multiple turns 'cheap' . With the Fed about to end its rate hiking cycle, the pressures on long-duration assets may be about to ease. Compared to peers, I believe the UTF fund is a solid choice with strong long-term performance.
For further details see:
UTF: Raising To A Buy On Relative Valuation