DNP: Long-Term Capital Preservation Combined With Consistent Income (NYSE:DNP)

Overview

DNP Select Income Fund (NYSE:DNP) is a closed end fund that aims to provide current as well as long-term growth of income for shareholders. The fund aims to generate its earnings by providing a diverse range of exposure to equities and fixed income securities in the Utilities sector. DNP has a public inception dating all the way back to 1987 and sports an expense ratio of 1.86%, which is very reasonable for a closed end fund. Closed end funds tend to get a bad reputation because it’s common to see these funds continually decrease in price and NAV over extended periods of time. What stood out to me about DNP is that the price has remained in the same range for over three decades. This kind of price consistency is top-notch, and the capital preservation is extremely valuable.

Looking at the long-term performance since inception, the price has only decreased 6.27%. Remember, DNP is best utilized for the income generation and not the capital appreciation. This rule generally applies to most closed end funds and should be considered before making any investment decisions. The current dividend yield sits at 8.2% and the consistent payouts have contributed to a solid total return greater than 800% since inception. DNP is top-notch when it comes to dividend consistency, as it has managed to maintain the same monthly payout for an extended period of time.

I also believe that DNP trades at a favorable valuation and would now be an attractive point of entry. Since the fund’s performance has remained so consistent, the price trades at a slight premium to NAV. After all, sometimes you have to pay a premium to get quality. Despite this, I believe that DNP’s underlying portfolio of assets will greatly benefit from future interest rate cuts that are likely to take place by the end of 2024. Let’s first start by taking a look at the fund’s portfolio of investments and the strategies that have been implemented to help deliver such consistent results.

Portfolio Strategy

DNP takes the unique approach of combining common stock exposure with varying weights in bonds and MLPs (Master Limited Partnerships). Under normal conditions, DNP may invest about 65% of assets into public utility companies that offer a range of essential services such as electric, has, or telecom services. As of the most recent fact sheet, DNP has the most exposure to common stock at 77%. This is followed by a 17% exposure to a range of bonds and cash, as well as a 6% exposure to MLPs. I imagine that this mixed approach is intended to take advantage of both income and growth traits, which helps give the fund a sense of balance.

I like that DNP also holds a very balanced approach to individual holdings, with none of them accounting for more than 3%. The largest position is currently CenterPoint Energy (CNP), accounting for 2.7% of assets. This is followed by weight in Sempra (SRE) and Ameren Corporation (AEE), accounting for 2.6% and 2.4% respectively.

The bond portion of the portfolio is quite solid, with almost all of the weight being exposed to investment grade debt. It is pretty common to see closed end funds include investments with poor credit ratings as a way to boost the distribution yield offered to shareholders. However, DNP manages to generate earnings while maintaining a majority of exposure to investment grade debt. In fact, only 1.4% of the portfolio is exposed to corporate bonds that are rated below investment grade.

Lastly, DNP implements leverage to amplify returns when the opportunity arises. The current leverage rate sits at 28% of the fund’s total assets, which can also increase the involved risk if investments do not play out as planned. DNP currently has $1.105B in total leverage outstanding which can be broken out as follows:

• $132M in fixed rate preferred stock.
• $200M of fixed rate senior notes
• $773M of floating rate secured debt outstanding.

The floating rate debt total is something that can be improved when interest rates start to get cut. As rates remain elevated to their decade high, this creates a higher cost for DNP to continue holding on to this debt. When interest rates are cut, this can increase operating margins to more attractive levels, which will allow for a greater amount of earnings to be retained within.

Dividend & Vulnerabilities

As of the latest declared monthly dividend of $0.065 per share, the current dividend yield sits at 8.2%. This monthly distribution can be extremely valuable for investors that depend on the supplemental income generated from their portfolio to fund their lifestyle expenses. While the fund has lacked any sort of long-term distribution growth, the consistency offered is still a great foundation for a long-term position. This prompted me to review the most recent 2024 semi-annual report to see if earnings can actually support the distribution.

For the last six months ending in April, DNP generated $0.73 per share of investment operation growth, which is comprised of both net investment income and net realized gains. Considering that the annual distribution amount totals $0.78 per share, the likelihood of the distribution being fully supported from earnings looks great. However, I do see some sources of weakness when looking at the NAV deterioration over the last five-year period. The NAV at the end of 2019 sat at $10.50 per share and decreased to $7.74 per share as of the latest semi-annual update.

One of the contributing factors to the NAV decrease is that there were some years where net investment income and realized gains were not enough to fully fund the distribution. Therefore, DNP implemented return of capital to fund the distribution, which gets pulled directly from the fund’s NAV. As a result, NAV deterioration can happen more rapidly when earnings are not strong enough and the distribution contains ROC.

Despite this vulnerability, DNP’s steady distribution rate has enabled long-term shareholders to continue growing their annual income amounts through a combination of reinvested dividends and additional capital invested on a continuous basis. To visualize this, I ran a back test of an original investment of $10,000 at the start of 2015. The below graph assumes that you made a fixed monthly contribution of $500 per month throughout the entire holding period, as well as reinvested all dividends back into DNP.

In the first year of your investment, the annual dividend income would have amounted to $978. Fast-forward to the full year of 2023, your dividend income would have grown to $6,868. This indicates a 7x increase in income despite DNP never actually increasing the monthly distribution rate. However, it should be noted that the distributions received from DNP aren’t the most tax friendly. The most recent section 19a notice states that the majority of the distribution is coming from net realized long term capital gains, accounting for 62%. 23% of the distribution on a fiscal YTD basis is being funded from net investment income, while the remaining portion is made up of return of capital.

The structure that DNP uses has the unfortunate vulnerability of no price growth over time. It’s always important to go into an investment with a clear understanding of what you are aiming to get out of it. DNP is best utilized as an income focused investment as the distributions are very consistent month after month and the price has remained in a stable range over since inception. Since DNP hasn’t delivered any price growth, it wouldn’t be the best fund for an investor that is looking for capital appreciation. There are plenty of other ways to maintain exposure to the utilities sector that can provide some meaningful price growth.

For instance, the most traditional alternative exposure would be the Utilities Select Sector SPDR Fund ETF (XLU). Over the last two decades, we can see that the total return of XLU has slightly outpaced that of DNP because of the price growth experienced. Choosing XLU would be the more tax efficient choice as well since the distributions are classified as qualified dividends.

Valuation & Outlook

Since the initial drop caused by the pandemic in 2020, it seems like DNP has not been able to catch a break. 2023 was a brutal year for DNP as the price continued to slide further and reach new lows. For reference, the last time the price was close to touching the $8 per share mark was following the Great Financial Crisis over a decade ago. So what exactly can be attributed to this drop? It seems that the aggressive interest rate hikes implemented by the Fed were a large source of this stress. The Fed hiked interest rates to their decade high throughout 2022 and 2023 and this negative impacted DNP alongside the rest of the utilities sector. As mentioned, DNP currently holds $773M in floating rate debt, and higher rates increase the cost associated with the debt.

To help paint a visualize, the below graph is a perfect display of this inverse relationship. We can see that as soon as interest rates started to get hiked, the price of DNP consistently slid downward. Utilities remain highly sensitive to interest rates as companies in this space are heavily reliant on access to debt financing. As rates rise, the cost of debt becomes more expensive and less attractive to hold on the balance sheet. This created a shift in the sector as companies in this sector could choose not to pursue different growth initiatives that could be costly and instead focused on cost efficiencies. This includes things like acquisitions, new plant development or construction, and even funding research and development.

Therefore, it isn’t too farfetched to see how interest rate cuts can be a positive catalyst for DNP. The unemployment rate has continually ticked upward over the last twelve months and now sits at 4.3%. As more households are out of work, this may cause a decrease in consumer spending as saving becomes the priority. Additionally, the US Presidential elections are still upcoming for 2024 and this may cause elevated levels of uncertainty and volatility in the markets. The combination of these factors adds to the case of the Fed being incentivized to cut interest rates and provide a bit of relief. A lower interest rate can ultimately boost valuation as well as give DNP some relief with the current levels of leverage that are used.

Since DNP operates as a closed end fund, the price can vary from the actual value of its underlying assets. DNP currently trades at a premium of 8.33% and despite this premium, I believe this is still an attractive entry point for a long-term buy and hold. For reference, DNP has traded at an average premium to NAV closer to 16.81%. Looking at the ten-year chart below, we can see that DNP has never fallen into discount territory, and this is likely due to its higher quality and consistent distribution rate. Quality can be expensive, so I am not surprised that DNP has maintained some level of premium over its NAV.

Risks

A lot of my confidence around the recovery of DNP is associated with interest rate cuts. There is always the risk that interest rates ultimately do not get reduced by the end of the year. This increases the probability that the fund’s NAV continues to deteriorate from underperformance from net investment income and realized gains. This has a spiraling effect because if the fund is not generating a sufficient level of earnings, then it may resort to using higher amounts of return of capital to fund the distribution. A larger percentage of return of capital would accelerate the rate at which the NAV falls. It ultimately comes down to whether or not DNP is able to efficiently capitalize on the lower interest rates and get back on track. So far, the price climb indicates confidence around interest rates, but we are still early in the process here.

We also have no insights to exactly how drastic or light future interest rate cuts are predicted to be. If rates are not significantly reduced, the fund will still see the impacts of the large leverage amounts held by having higher costs associated. Not only would DNP suffer from an ongoing period of higher costs, but so would the underlying holdings within the fund. As it stands, the Z-score over the last three-month period already sits higher than usual at 2.17x. Despite the current premium being a bit more attractive than normal, the recent price volatility has caused this Z-score to spike above its normal one-year average of -0.61.

Like previously mentioned, US Presidential elections can cause there to be higher levels of volatility in the market. DNP’s price can easily reverse to the downside if markets shift and fall into a recession. Unemployment rates are rising and this could impact consumer spend around the demand and usage within the utilities sector. However, inflation levels have consistently decreased and helps offset these concerns for now.

Takeaway

In conclusion, DNP is an excellent fund that provides a diverse range of exposure to the utilities sector. DNP is best utilized as an income investment since the fund has shown no price growth since inception but has maintained the same distribution rate throughout. This level of consistency makes DNP a great choice for investors that want capital appreciation while also providing a monthly distribution. The price currently trades at a lower premium to NAV than usual, which may indicate a great time for entry. Additionally, I believe that future interest rate cuts can serve as a positive price catalyst for DNP as it relieves the fund of elevated costs of its floating rate debt and also improves the valuation of underlying holdings. Therefore, I rate DNP as a buy.