High-Yield Hunting

One of our longtime laments is that there are few funds that do a decent job of tracking utilities. And there are even fewer that offer attractive yields.

Sure, we’re stock pickers first and foremost. But we can’t ignore the fact that funds offer a fast way of gaining diversified exposure in a single investment vehicle.

Indeed, many investors who pride themselves on their stock-picking prowess still own funds as core holdings.

Unfortunately, there are really only a couple of actively managed utility funds that deliver the yield and performance that income investors are seeking. But they also come with significant caveats.

One of our favorites employs substantial leverage to enhance both yield and returns, while the other does the same and isn’t exactly a pure-play on utilities.

As such, we’re always on the hunt for new ideas. And sometimes our subscribers come up with intriguing ones on their own.

One of the many perks of subscribing to Investing Daily’s Utility Forecaster is that you can pose questions directly to the editors via our monthly Live Web Chats and Stock Talk forum.

Happily, the benefits of this ongoing dialogue run both ways, particularly when subscribers point us to securities that we may have missed.

Usually, there’s a good reason when a stock or fund isn’t on our radar.

Recently, for instance, a subscriber asked our opinion about a high-yielding telecom stock. Among the problems revealed upon closer inspection, however, is the fact that the stock is a micro-cap with daily trading volume so thin that even a modestly sized purchase would move the market.

Still, it’s always a useful exercise to kick the tires on securities, even when they don’t meet our stringent criteria.

A Hot Tip

In fact, we have one subscriber who’s been kind enough to regularly forward us a rundown of his latest ideas.

Among the securities he detailed in his most recent packet is a closed-end fund that specializes in utilities and whose monthly distribution offers an enticing yield of 7.4%.

Sounds good, right?

Equally important, the actively managed fund has succeeded in beating the main utilities benchmark by an average of 2.6 percentage points annually over the trailing 10-year period, for a total return of 9.3% annualized. And it’s outperformed its benchmark by similarly wide margins over other time periods as well.

Like Utility Forecaster, DNP Select Income Fund (NYSE: DNP) takes an expansive approach to the utilities space, with traditional holdings in electric, gas, and water utilities (64% of assets) as well as telecoms (12%) supplemented by energy production and transportation (22%).

Details, Details

All systems go?

Well, maybe. As a closed-end fund (CEF), DNP is allowed to employ significant leverage to boost its yield and returns.

Right now, its total leverage ratio is around 27%, which means that for every $1 of investable capital about $0.27 is derived from leverage. In the wrong hands, such leverage can cause greater volatility and take a big bite out of returns during selloffs.

Fortunately, DNP’s seasoned management team appears to use leverage judiciously. In the bear market year of 2008, for instance, we would have expected the fund to lose far more than the main utility benchmark. Instead, DNP equaled its performance.

Things didn’t go nearly as well in 2015, which was a bad year for both utilities and the broad market. On a net asset value (NAV) basis, the fund fell short of the average utility by about 8 percentage points.

But we shouldn’t judge the fund on the basis of a single year, especially when it’s produced superior returns over most longer-term periods.

The Dreaded Return of Capital?

Another potential concern is that in recent years, return of capital (ROC) has become a bigger component of DNP’s monthly distribution. In the fund’s 2015 and 2016 fiscal years, for instance, ROC accounted for 10% and 17%, respectively, of annualized distributions.

In some cases, a fund may resort to ROC in order to avoid liquidating its winners simply to make its monthly payout. Other times, it might use ROC as a temporary fix due to the timing of dividends and other investment income it receives and then pays out to unitholders.

But there’s also a more nefarious scenario in which a fund habitually uses ROC to maintain the illusion of a high distribution when what it’s really doing is giving unitholders their own money back net of management fees. In such cases, ROC is typically considered destructive to shareholder value.

Upon closer scrutiny, however, it looks like DNP’s ROC is actually the result of its sizable allocation to midstream master limited partnerships (MLPs), which accounted for about 10% of assets at the end of October.

Because the vast majority of MLPs’ distributions are considered return of capital, then that likely explains why the fund’s own distributions have had a return of capital component (even though the definition of ROC is different for each type of security).

Okay, so far, so good.

The Bottom Line

So is DNP a buy? Not at present, and here’s why.

Unlike mutual funds, closed-end funds trade on exchanges, which means their prices can deviate markedly from their net asset values.

Right now, DNP trades at an 11.3% premium to the value of its underlying portfolio. And even though utilities are in correction territory, most still trade at moderate premiums to their long-term valuations.

In other words, if you were to establish a position in DNP right now, then you’d essentially be paying a double premium. As value-oriented investors, that’s totally unacceptable.

Nevertheless, prices fluctuate, and premiums can eventually turn into discounts. Over the past five years, however, DNP has consistently traded at a premium to NAV.

But with the Federal Reserve forecasting as many as three rate hikes this year, patient investors could finally get an opportunity to pick up DNP at a discount.

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