Evaluating Closed-End Funds: DNP To Do Well With Rising Rates

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Investment Thesis

This article will take a look at DNP Select Income Fund (NYSE:DNP).

What I look for in a CEF is a stable flow of income. I have developed a method of determining whether a specific CEF could provide a reliable stream of income. I developed my method after reading this article. My thinking is that rather than the share price, how the portfolio of the fund behaves and the income it generates is the determining factor in the reliability of the distribution.

I think it is a mistake to see the fund’s NAV as the sole component of the fund’s value, but rather I think it is more productive to look at a fund’s NAV as the muscle that it uses to generate cash. So while it can be bad if the fund is eroding NAV (look at it as muscle atrophy), it is the fund’s ability to generate cash that is the true value. I look at a specific CEF and apply that method to determine if the fund has been supporting the distribution. Then based on current holdings and past performance, I try to determine whether or not the fund will be able to support the distribution in the future. You can read an explanation of my method and get links to the other articles in the series (published before March 27, 2022) here.

DNP Select Income Fund

I last wrote about DNP here where I very much liked its lack of drama and consistent distributions. And since last August there haven’t been a lot of changes to write about (thus confirming my view that it was very low drama). So while it was doing a very good job of covering its distribution 8 months ago, how is it doing now?

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Data by YCharts

Over the last 12 months, DNP has managed to earn 20.8% total returns on its portfolio. That is pretty impressive. But as we have seen with some funds, impressive returns can be frittered away by paying too large a distribution. Has DNP done that? Or has it continued to manage its portfolio well and covered its distributions?

Let’s take a look at how the NAV has performed over the last year to get our first metric on how well DNP is managing its portfolio.

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Data by YCharts

Over the last year, NAV has gone up 11.4%. That is a very good sign that the distribution is covered. My only concern is that much of this increase is quite recent. So, what do the distributions look like?

Distributions and sources

DNP Distribution History (CEFData.com)

Income from its holdings makes up a little over a third of the distributions, which is slightly better this year than over the last 3. Long-term capital gains are roughly half of the distribution. ROC represents most of the rest. Given the NAV performance, that hasn’t been destructive this year.

DNP still has a very comforting lack of drama. The yield on NAV over the last 12 months works out to be 8.04% using the average NAV. The yield on NAV is even lower at 7.26% using the maximum NAV over the last year. Both of these are well below that total NAV return of 20.83%. Combined with the increase in NAV this indicates a well-covered distribution.

Long-Term Trends

Any fund can have a good year or a bad one for that matter. So I like to look beyond just a single year in determining the history that I will use to help me project future performance. A 3-year period seems to me to be a good length of time without including data from too long ago.

So how has DNP done over the last 3 years?

Chart
Data by YCharts

A total NAV return of 35.9%, which works out to be a 3-year CAGR of 10.74%, is quite impressive. Here I also see a more averaged upward trend unlike the spike at the end we say when looking at the 1-year performance.

So how has DNP managed the value of its portfolio?

Chart
Data by YCharts

For distribution coverage, all we need is for NAV to be flat. But we see a slight uptrend. While a growth rate of 2.04% isn’t huge, it is more than sufficient to cover the distribution. But to be sure, let’s compare the yield on NAV to the total NAV return.

My work is made easy by the fact that DNP has paid out a constant 6.5 cents a month distribution for many years. So the total paid out over the last 36 months is easily calculated on works out to be $2.34. That produces a yield on NAV of 24.34% (total, not an annualized number) using the average NAV of $9.614. This is also an average yield of 8.12% per year. With a total NAV return of 35.92%, the total yield on NAV is lower and indicates a distribution that is covered. The annual average yield of 8.11% is also below the CAGR of total NAV return (10.74%) which again indicates a covered distribution. Given the increase in NAV, modest though it is, combined with the portfolio’s performance exceeding the distributions, I judge the distribution well covered.

Chart
Data by YCharts

Looking at the NAV history over the last 10 years, we also see that management has done a good job of keeping the value of the portfolio. The gains are modest, averaging just over 3% a year, but again, very little drama here.

Historical Distributions

Distributions (CEFData)

Finally, we can see that since 2011 the distribution has been 6.5 cents a month. DNP has actually done even better than that. Since its inception in 1998, aside from a few year-end special distributions, the distribution has been 6.5 cents per month. While there have been both good times and bad during the fund’s run, investors have been able to count on that distribution each month.

Future Distribution Coverage

It is very good that DNP has had good distribution coverage in the past. But investing is about the future. So while DNP’s past performance means it is more likely to continue its distribution coverage, we do need to look for signs that this might change.

Asset Breakdown

Asset Types for DNP Portfolio (CEFData)

Last year, I was concerned that DNP had close to 15% of its portfolios in bonds (mostly US-based bonds). With interest rates heading up, this looked to me like it would be a drag on the value of the portfolio. The current percentage of bonds in the portfolio is little changed, but so far the bonds haven’t been an obvious drag on portfolio value. Looking at the latest data on the bonds, the average duration has declined slightly to 4.5 years from 4.8 years. That is a good move in a rising rate environment.

Holdings

Industry Exposure and Top 10 (CEFData)

The Top 10 holdings and industry exposure is pretty much unchanged since last August (although the relative sizes of some of the positions have changed a bit). Crown Castle (CCI) has dropped out of the Top 10, but mostly because it now requires a larger holding to make that list. Energy and utilities are still very attractive sectors and that remains where DNP has its largest holdings. I see no red flags here.

Chart
Data by YCharts

We are in a time where interest rates will be increasing, so it pays to look at how the utility sector and DNP specifically did during the last time the Federal Reserve significantly increased interest rates. And as we can see in the chart above the utility sector did well. And DNP did even better.

Chart
Data by YCharts

Looking at the premium to NAV over the last 10 years, we can see that currently DNP is trading at a 10.13% premium. While some may believe that it is a bad time to buy a CEF when it trades at a premium, I look more at the relative valuation. And 10.13% is significantly below the 13.53% average premium the shares of DNP have been trading at during the last 10 years.

Conclusion

DNP continues to have very little drama. While the share price is up almost 10% from just 8 months ago, that isn’t a huge increase given the big changes in energy prices. With the shares trading hands at a price that is a lower premium to NAV than the average of the last 10 years, I think the price is fine to buy. And more importantly, the distribution remains well covered.

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