2024-01-01 02:45:45 ET
Summary
- A couple of months ago, I issued an article on UTF elaborating on the potential red flag areas that are associated with higher for longer scenarios.
- Now, once the interest rate environment has improved and the chatter has moved from how long to how many cuts, UTF's prospects have strengthened accordingly.
- In this article, I provide three reasons why it now makes sense to go long UTF and why the current dividend of 8.5% is safe.
Back in September, this year, I issued an article on Cohen & Steers Infrastructure Fund ( UTF ) expressing some concerns about the near-term performance as well as the underlying dividend.
While I liked the structure and the overall asset allocation policy (e.g., bias towards infrastructure companies that enjoy long-term tailwinds) of UTF, there were two areas of concern, which effectively stemmed from the same nuance - i.e., higher interest rates.
Before going into Q4, 2023, it still seemed that the interest rates would assume a "higher for longer" scenario. There was no material chatter around several rate cuts already in 2024. So this, obviously, implied an elevated risk for UTF to protect its NAV value, while managing to accommodate the ~8.5% dividend.
The first area of concern was the fact that UTF had (and still has) sourced in external leverage, which explained 30% of the total asset base. A significant chunk of these proceeds were locked in at fixed interest rates and below market level. In the case of refinancing this at higher or more market-aligned interest rates, UTF would face serious headwinds in terms of its ability to cover the dividend.
And second issue was related to the underlying companies of UTF that inherently carry quite debt-saturated balance sheets, where higher rates would eventually impose a drag on their ability to distribute high-yielding dividends (which is a major source of UTF's cash flows).
Now, if we look at the chart above (starting from the date of when my article was published) we can see that UTF was in a notable decline until November when more positive news around interest rate policy popped up.
The fact that at one point UTF was down 15% in just ~30-day period and then once the positive news came in surged higher confirms that UTF is heavily exposed to the interest rate risk.
Thesis Update
With the aforementioned and the assumption of normalizing the interest rate environment in mind, let's take a look at UTF's prospects to sustain its attractive dividend and deliver acceptable returns as we go into 2024.
There are also two aspects, which I want to highlight in the context of relatively favorable interest rate projections.
The first is related to the structure of UTF's external leverage profile. As we can see in the table below, the lion's share of these borrowings is based on fixed interest rates, which help bring down the aggregate financing cost for UTF.
Currently, UTF's weighted average cost of financing stands at 2.5%, which is way below the prevailing market-level financing rate. The relevant financing rate would be something that is closer to the variable rate component - i.e., 6.2%.
Now, once we have a rather high clarity on that the rates have peaked and that over 2024 there will be a convergence toward accommodative levels, UTF's leverage profile seems more acceptable.
The most important aspect here is the weighted average term on fixed financing. As of now, it is ~ 2.8 years, which allows us to assume more safely that UTF will manage to avoid rolling over fixed-rate debt with very expensive debt that would challenge the sustainability of its dividend.
The second is connected with UTF's asset mix.
This pie chart clearly depicts how concentrated UTF is in the infrastructure businesses. Plus, we can also notice that ~18% of the total AuM is placed into fixed-income type securities (e.g., corporate bonds and preferred shares).
The benefit here is very simple: The duration factor provides a significant boost for UTF's holdings.
In other words, as infrastructure businesses tend to hold relatively huge amounts of debt mainly due to the stability and predictability of cash flows, any positive rate of change dynamic in the cost of financing gives a material benefit to the free cash flows. This, in turn, enables higher valuations and safer dividend coverage ratios.
Furthermore, we have to also appreciate the fact that most of these infrastructure companies have taken long-term borrowing to maximize the match of asset and liability profiles. The longer the duration profile of the debt instrument, the higher impact there is from any changes in the SOFR.
Finally, since the publication of my article, UTF has fallen into a discount territory compared to its current NAV.
The prevailing discount of ~4.5% provides an additional benefit for long-term investors, who seek to buy and hold UTF with an aim to collect its high-yielding dividend.
The Bottom Line
The improved interest rate environment (i.e., clarity on the peak level) and the general consensus of declining interest rates already in 2024 have put away some of the pressure from UTF's prospects to maintain its 8.5% dividend in a sustainable manner. Considering that the weighted average term on fixed financing is ~ 2.8 years, UTF has enough time before having to roll over the fixed-rate borrowings. This means that even if the SOFR decreases at not as accelerated pace as it is currently predicted, UTF will still be fine from the cost of financing perspective.
As a result of this and taking into account the exposure to sound infrastructure businesses and high-yielding dividend, I would rate UTF a buy.
For further details see:
UTF: This 8.5% Yielder Has Become More Attractive