BUI & DNP: Utility Funds Get Too Expensive

BlackRock Utilities, Infrastructure & Power Opportunities Trust (BUI), despite recent outperformance driven by a weak US dollar and a shift to a 5% premium, is now rated a 'sell' due to its extreme valuation and the broader utility sector's overextension. The Utilities Select Sector SPDR Fund (XLU) currently yields 1.72% less than 10-year Treasuries, signaling a historically poor risk-reward profile for the sector, with potential for over 50% declines. Given the high premiums and leverage risks in most utility CEFs, the article suggests higher-rated preferred shares or bonds, such as Brookfield BRP Holdings subordinated notes yielding around 7.7%, as more compelling alternatives.

Analysis

BlackRock Utilities, Infrastructure & Power Opportunities Trust (BUI) has demonstrated notable outperformance over the past six months, an unusual feat for a non-leveraged, covered-call writing fund. This performance was primarily driven by two temporary factors: a weak U.S. dollar which benefited the fund's international holdings, and a significant swing in its valuation from a discount to a 5% premium over its Net Asset Value (NAV). However, the underlying utility sector now presents a historically poor risk-reward profile. The dividend yield for the sector benchmark, the Utilities Select Sector SPDR Fund (XLU), is currently 1.72% below the 10-year Treasury yield, a spread that signals extreme overvaluation. A reversion to historical fair value norms, defined as a 2% yield premium over Treasuries, could precipitate a sector decline of over 50%. BUI's own 5% premium and its extreme Z-score have moved it into a sell-rated territory. While the fund has defensive features, its out-of-the-money covered calls offer limited protection, and its European exposure is not a sufficient offset. Alternatives like DNP are also unattractive due to high premiums and leverage, leading to the conclusion that investment-grade credit, such as the BBB-rated Brookfield subordinated notes (BEPH, BEPI) yielding approximately 7.7%, offers a more compelling proposition.

Key Decisions for Investors

• Given BUI's historically high 5% premium to NAV and the extreme overvaluation in the broader utility sector, investors should consider taking profits and exiting positions in the fund.
• Exercise significant caution with the entire utility sector, particularly leveraged closed-end funds like DNP, as the negative yield spread relative to 10-year Treasuries indicates a highly unfavorable risk-reward setup.
• For investors seeking yield, reallocating capital from utility equity funds to investment-grade subordinated debt or preferred shares, such as the mentioned Brookfield notes yielding around 7.7%, may offer a superior risk-adjusted return.