UTG CEF: Recent Fed Decisions Highlight Why This Fund’s Strategy Isn’t Working

Some investing strategies work in any economic environment, but most individuals will need to adjust their portfolios in a changing financial landscape even as their long-term goals remain the same.

The investing environment has changed drastically over the last three years, since inflation began to rise in early 2021, and the Fed has increased rates significantly over the last several years. The changing financial situation has had a disproportionately negative impact on certain types of investments. One preferred type of investment that has been hurt significantly by inflation and rising rates has been leveraged income funds such as the Reaves Utility Income Trust (NYSE:UTG).

UTG performed very well for many years when rates were low for an extended period of time. This fund has offered investors total returns of nearly 494% since the closed-ended fund’s inception in early 2004.

Still, this investment fund has consistently struggled over the last 3 years.

The Reaves Utility Fund has offered investors total returns of just .50% over the last three years, while peers such as the Utilities Select Sector SPDR are up nearly 10% using total returns during the same era (XLU).

I last wrote about UTG in April of 2023. I rated the fund a sell primarily because of the weak outlook for the utility industry and because of how higher rates are negatively impacting the leverage that this closed-ended fund has relied upon to pay out income. I am downgrading the fund to a strong sell today. The Reaves Utility Fund is increasingly relying on long-term capital gains to make payouts, and the cost of the leverage the closed-ended fund is using is too high for this fund to offer investors any substantive income or total returns in the current inflationary environment. The outlook for the utility industry remains poor as well for multiple reasons.

The Reaves Utility Fund is invested 57.60% in utilities, 21% in Communication, 7.07% in the Industrials, 6.26% in Energy, and 8.48% in Real Estate. UTG uses leverage and invests over 100% of the listed assets. The fund has an expense ratio of 2.23%, a current yield of 8.53%, and assets under management of $2.03 billion. The fund invests mostly in large-cap utility stocks. The largest holdings of UTG are Deutsche Telekom AG (OTCQX:DTEGY), Constellation Energy (CEG), Public Service Enterprise Group (PEG), and PPL Corp. (PPL)

Since 2015 this fund has increasingly relied on long-term capital gains to make distributions primarily because the short-term income being generated by this closed-ended fund has not been sufficient to maintain or increase dividend payouts. The fund’s payouts have also risen by $.05 a share since 2021, and UTG has increased payouts by just 2.25% over the last 5 years.

This fund is now borrowing at a higher rate of nearly 4.81% along with an origination fee of around .65%. The higher leverage costs are part of the reason this CEF is drawing on long-term capital gains to pay the distributions, in my reasoning. The leverage this fund is using does not work in a higher rate environment as we are currently in and is likely to remain for some time.

This is also why the Fed’s recent statements and Powell’s recent comments are important. The Federal Reserve Chairman has frequently stated that the process of getting overall price levels down in the US economy will likely take years. Even though inflation rates have come down, prices remain high. Powell’s recent comments that the Fed is not prepared to move rates substantively without clearer signs of lower inflation show how dovish the Fed chairman has become in the current economic environment.

While if the rate cycle end and prices came down significantly the Utility sector would benefit more than most industries, the outlook for the utility sector is likely to remain negative for some time for several reasons. The industry is going through a transition where cap ex is likely to be elevated for most companies as the sector transitions to using more renewable energy, higher rates will make refinancing this high-debt industry’s bonds more expensive. Sales in this industry are also expected to increase by just 2 percent. Fitch downgraded the utility sector at the beginning of the year primarily because of the higher costs and capex most companies in this industry will deal with.

Different investing strategies have worked more effectively in varying economic environments, and most higher leverage funds such as UTG are struggling in a high-rate environment. While this fund outperformed most peers and the S&P 500 (SPY) for much of the last 2 decades, this closed-ended fund is likely to continue to underperform moving forward.