DPG: Leverage Will Be More Costly, But Income Is Stable

Duff & Phelps Utility Infrastructure Fund (NYSE:DPG), much better known as DPG, commanded a bit of a premium when we last looked at it that didn’t seem worth it. We now think that DPG investments are relatively well positioned and that the income proposition bears consideration. While leverage costs are rising and this affects the DPG strategy, key exposures offer a resilient baseline income that we can appreciate in an environment where dividend yields give returns a nice head-start. Overall, with real asset positioning, DPG is worth a look.

The Economic View

It is pretty obvious to everyone that we are going into a recession. Nothing is good about our current economic environment, and the economic failing are as malignant as possible all being cost push and productivity related issues. Tangible assets lie at the root of global productivity, providing and distributing energy and acting as key infrastructure for global enterprise. DPG offers that in spades with its exposures. Moreover, with the equity markets being highly unstable, and low clarity on the extent to which markets have corrected for the inevitable recession, dividend yields are going to be important for investors. Rising rates to tackle inflation simply means economic value destruction will come from crimped household income and destroyed asset wealth rather than eroded purchasing power, and with it being unclear how leading the stock market is with respect to the economic hurt we’ll see in the statistics over the next 8 months or 2 years, depending on the severity of our bear market, a dividend yield means a head-start on returns where capital appreciation is unreliable.

DPG Exposures

DPG offers strong real asset exposures. The fund is leveraged by 40%, but this borrowed cash is being put to work in cash generative companies. While some utility exposures are underwhelming as we detailed in our previous article, the turn in commodities offers some respite for more exposed stocks, where much of DPG exposures are commodity market resistant on the demand side.

Oil & Gas

30% of the DPG portfolio is allocated to Oil & Gas. Of all the commodities that have boomed of late, these are the least connected to an overheated good market, and are less likely to fall as rates rise due to durable changes to the demand side. Oil supply has been underinvested and even the greatest OEPC nations have little spare capacity. With Russian supply falling away as an option for the western bloc for import, the Ukraine invasion has made total supply permanently lessened and prices structurally supported. Where DPG has commodity exposures it is to oil and gas, which we believe are more durable in the coming recession due to supply side issues. With refining being the biggest beneficiary of overheated goods, there is a decent buffer to the price of oil when good markets turn.

Moreover, DPG’s oil and gas exposures are not so skewed towards businesses that are commodity exposed. Many investment are in companies that operate or own real assets merely involved in the transport of commodities such as Enterprise Products Partners (EPD) and Kinder Morgan (KMI). These along with many other commodity infrastructure plays make the brunt of the oil and gas exposure.

Utilities

In addition to oil and gas, major exposures are within utilities. Here we have stocks that indeed are somewhat unimpressive, mainly companies that deal a lot of with retail energy markets, where governmental intervention could limit profitability in some markets, especially outside the US, and companies that generate electricity from inputs such as gas that have rocketed in price.

However, there are several points of strength within the 76% of the portfolio allocated to utilities. We look in particular at companies like Energias de Portugal (OTCPK:EDPFY), which has a profile that represents much of DPG’s exposure in these markets. Firstly, they have renewable assets. While the renewable narrative is getting a little tired, renewable assets, beyond producing electricity which is an essential resource, will always have a market for assets due to the amounts of money being earmarked for the renewable transition. This means a backstop for the fall in their asset values. Other stocks in DPG’s portfolio that benefit in this manner are Orsted (OTCPK:DNNGY). Moreover, EDP like many other stocks in this exposure including National Grid (NGG), operate regulated utility concessions. Regulated utility concessions are remunerated by governments to private company operators in the following way: regulated WACC * the regulated asset base. To grow the regulated asset base regulated utilities need to propose projects, often green energy projects, to the government and then to develop them. The WACC is determined periodically and is updated to flex with inflation and interest rates, providing an inflation hedge. With both renewable projects as a sink for growing RAB and WACCs being relatively protected against inflation, things look decent for many DPG utility, water and gas exposures.

Bottom Line

DPG is quite levered at 40%, and these leverage costs will rise as interest rates do as all the leverage of DPG is connected to Libor. With borrowing costs being around 1% at trough levels for treasuries, we entirely expect that those borrowing costs will rise to 3% as the hike cycle continues. This means meaningful growth in leverage that accounts for 40% of the asset value. This will have a bit of an effects on income. However, we like where DPG has placed this borrowed money. Cash generative and tangible investments, in particular those exposed to safer commodities such as oil and gas that benefit from structurally favorable supply, as well as assets that are remunerated on a non-market basis by governments, provide a lot of guaranteed cash flow despite the current environment to support the hefty 10.5% dividend yield. While borrowing costs are rising, the dividend is mostly sustainable on the basis of the assets if DPG so chooses since the underlying assets should see net flat or growing dividend yields to keep some spread over the rates. It may decline, but there is a margin there to still get good income. With dividends proving some amount of certainty in an environment where investors should be worried about scope for capital appreciation, DPG stands out as a nice exposure.