2 Dividends Set To Soar When The Fed Cuts Rates
Co-authored with Hidden Opportunities
Interest rates act as a financial winter, chilling economic activity by increasing the cost of borrowing and cooling consumer spending. Conversely, rate cuts can thaw the freeze, invigorating investment and stimulating growth across various sectors. Lower interest rates encourage borrowing and reduce the cost of variable-rate debt. That combination generally benefits business growth earnings, driving investor interest, and resulting in higher stock valuations.
While the broader market is eager to see rates decline, certain economic sectors specifically benefit from falling interest rates. Depending on the circumstances, utilities and fixed income will be notable beneficiaries of this eventual move by the Federal Reserve.
Utility stocks are defensive dividend-payers backed by an inelastic business with demand irrespective of the economic climate. In terms of investment dollars, they share the pie with bonds, which become more attractive when interest rates drop. As such, the relative appeal of utilities rises along with their dividends, as rates come down. Similarly, preferred securities, with their fixed dividend payments and bond-like characteristics, also flourish amid falling interest rates.
Let’s explore two investment choices that not only offer attractive dividends while waiting for rate cuts but also position you for significant total returns as the economy shifts.
Pick #1: UTG – Yield 8.7%
After a relatively mild winter in 2023, The U.S. Energy Information Administration expects hotter summer temperatures this year, resulting in an estimated annual residential electricity consumption increase of almost 4%. This is a non-discretionary expense and will happen irrespective of the strength of the consumer or the economy.
Utility bills are directly correlated with inflationary pressures on generation and transmission. Companies pass along higher fuel costs to consumers. Across the United States, on average, electricity costs rose 0.9% on a seasonally adjusted basis in March (vs February), and 5% YoY according to the latest consumer price index. This is on top of the 10.2% YoY increase last year. Even though natural gas prices are at historic lows, the costs of transmission and distribution are rising fast. Moreover, utility companies are spending heavily to ramp up their transmission infrastructure as electricity demand grows because of the advent of electric vehicles and data centers for artificial intelligence applications. We expect these costs to be slowly passed along to the consumer.
“I expect it to accelerate. A lot of spending has yet to hit the consumer bill.” – David Springe, executive director of the National Association of State Utility Consumer Advocates
Utilities represent a dividend-friendly inelastic business with excellent inflationary protections, making them an ideal companion for an income investor. Reaves Utility Income Fund (UTG) is a CEF (Closed-End Fund) composed of predominantly U.S.-based utility, communication services, REITs, and industrial companies. Source
UTG has a solid track record of distribution growth, with no reductions since its inception in 2004. The CEF pays $0.19/month, an 8.7% annualized yield.
UTG operates with a ~20% leverage, offering prospects to boost returns as the catalysts take effect. As of October 31, 2023, UTG’s borrowings had a weighted average rate of 5.42%. UTG’s distributions during FY 2023 were primarily NII (Net Investment Income) and capital gains, providing favorable taxation for eligible investors. The CEF maintained its composition during the three months of FY 2024.
While inflation poses minimal challenges for the utility and infrastructure sectors, several promising factors lie on the horizon. Foremost among these is the substantial investment by the U.S. government in infrastructure and clean energy. Additionally, interest rate reductions serve as a prominent catalyst, enhancing the valuation of this sector, which has traditionally been viewed as a bond proxy.
Pick #2: DFP – Yield 7.2%
The market remains distracted by inflation data and the Fed’s narrative around interest rate policy. This is the time to buy and hold income-producing assets while they remain discounted. Fixed income continues to present an excellent bargain to buy, and get paid to wait for the Fed to cut rates.
Flaherty & Crumrine Dynamic Preferred and Income Fund (DFP) is a CEF. The firm has a long history of managing CEFs. Since its inception in 1983, its expertise has been preferred securities for institutional clients and investment funds.
DFP holds 210 securities, with ~49% of the fund’s assets deployed in investment-grade securities, and ~79% of the fund composed of banking and insurance sector preferreds. These are highly regulated institutions with strict regulatory capital requirements and often demonstrate double-digit coverage for their preferred dividends. Source
For FY 2023, 99.8% of the CEF’s distributions were QDI, making them highly efficient from a taxation standpoint for eligible investors. We note that due to its high exposure to the financial services sector, the fund typically achieves a high +80% QDI for its shareholders.
DFP is a leveraged CEF operating at 39.5% leverage. The fund has a 91% fixed-to-float exposure, with the floating component carrying a SOFR + 0.9% interest rate on the borrowed balance. DFP’s effective weighted average duration of debt stands at 2.9 years, with an average coupon of 6.93%. This eats into the fund’s bottom line, resulting in declining distributions amidst a record pace of rate increases.
Let’s review the effects through the chart below. Observe the steady rise in TII (Total Investment Income). This means DFP’s assets are earning more through active management of fixed-income securities in the hawkish environment, but all of it isn’t translating into shareholder distributions due to rapidly rising interest expenses.
Given DFP’s floating-rate exposure, higher rates almost immediately reflect on the fund’s expenses, shrinking the NII (Net Investment Income), and resulting in a decline in quarterly distributions. With rates almost at their peak, we don’t expect interest expenses to materially decrease until the Fed pursues rate cuts. And rate cuts will directly translate into higher NII and growing distributions. It is a question of time, and DFP ensures you get paid to wait for this.
DFP currently trades at a sizeable ~12% discount to NAV, a level not seen since its inception.
This rate uncertainty-driven sell-off is a buying opportunity for the rate-agnostic investor, to ensure excellent total returns when rates decline.
Conclusion
The topic of concerns over high interest rates reminds me of this line from my favorite poem.
“If Winter comes, can Spring be far behind?” – Ode to the West Wind, Percy Shelley
As the cycle of seasons persists, so too does the economic cycle; just as winter yields to spring, high interest rates will inevitably give way to lower ones, paving the path for periods of growth and progress in the economy. Low-rate environments will encourage income investors to shift away from cash equivalents and treasury funds into dividend-focused sectors, improving valuations and leading to big upside from current levels.
Utilities and preferred securities stand to be the biggest beneficiaries of rate cuts. This is why we are accumulating UTG and DFP, among other income-focused securities, to collect waiting fees as we position ourselves for significant upside. The Income Method, as we call it, is our secret to navigating economic uncertainties in retirement.