Taking a Closer Look at UTG's Distribution Safety in Light of Recent Performance Struggles

One of our members recently reached out wondering about the safety of UTG's distribution. He pointed out the rising proportion of distributions from long-term capital gains since 2014, noting that these are less secure than those from dividends and interest generated by the fund's underlying holdings.

Given the popularity of UTG, we are sharing our response below with all of our members. Feel free to reach out if you have any questions...
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We are not too worried about UTG's distribution at this time. If performance still does not improve over the next 1-2 years, we could begin to feel differently.
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​At a high level, a CEF distributes a percentage of its net assets each year ("NAV distribution rate"). The total returns (dividends plus price appreciation) earned by a fund's portfolio ultimately need to exceed the fund's NAV distribution rate to avoid eroding assets over the long run.
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​One of the biggest signs that a distribution could be unsustainable is a prolonged decline in a fund's NAV per share. While UTG's NAV per share has fallen over the last couple of years, it has remained stable to higher over longer periods of time.
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​Historically, UTG distributed around 5-6% of its NAV each year, and the fund's long-term annual returns have been around 9% to 10%. This allowed UTG to pay growing dividends and increase NAV per share by holding onto significant unrealized gains.
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​In recent years, the performance of UTG's portfolio has been lackluster.
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​Since February 2020 (the onset of Covid), the utilities sector (XLU), which accounts for 60% of UTG's assets, has delivered an average annual return near 2%.

Telecom stocks (19% of UTG) have fared even worse. And many REITs (8%) have been under pressure. Rising interest rates and a rotation to growth stocks have been two of the biggest headwinds.

Due to these challenges, UTG's NAV has compounded by only 4.8% over the last three years, well below its long-term average closer to 9-10% and falling short of the fund's NAV distribution rate of around 6% during this period.

Since distributions exceeded investment returns the last couple of years, NAV per share has fallen from around $35 to $27.88 today.
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​But UTG's annual distribution of $2.28 per share has remained steady, resulting in an elevated NAV distribution rate of 8.2% ($2.28 per share in distributions divided by current NAV per share of $27.88).
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​Will UTG's total returns (dividends plus price appreciation) be able to cover an 8.2% distribution rate going forward? That's the big question.
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​Given UTG's longer-term performance track record (9-10% annualized NAV returns since 2004), plus the out-of-favor nature of many utility, telecom, and REIT stocks (improving their forward-looking return potential), we think the fund deserves the benefit of the doubt to bounce back in the years ahead.
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​But what about the shift in the distribution's composition that you pointed out?

You are correct that in recent years UTG's payout has consisted primarily of long-term capital gains (orange bars) rather than dividends paid by underlying holdings (dark blue bars).
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​All else equal, dividends are a more reliable source of return for funding distributions than capital gains, which are unpredictable any given year.
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The driver behind UTG's distribution composition shift isn't that clear to me. The portfolio's allocations in 2014 (the year before the shift began) were very similar to UTG's current mix of sectors, so it's not like the fund rotated to lower-yielding stocks to explain the drop in qualified.
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​My best guess is that UTG took its leverage much lower (leverage had never been below 20% prior to 2017), and that in turn reduced the dividend income the portfolio generated.
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Another way to look at this is NII Coverage, which is the percentage of a fund's distribution covered by net investment income (NII) – the dividends and interest earned by the fund less expenses.

We can see that UTG's NII coverage tracked lower as the fund's use of leverage decreased, suggesting that could be a meaningful contributor to the distribution's change in composition.
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UTG's NII coverage hovered near 30% in the six-month period ending in ​April (the latest data available). While that might sound low, it's higher than all but one of the other six utility-focused CEFs that exist.
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​Most equity-focused CEFs rely heavily on capital gains (NII coverage across all equity CEFs is around 5%), so UTG's mix of dividends versus capital gains doesn't concern us too much. Total returns matter the most.
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​The biggest factor to watch is whether performance rebounds enough to return to covering UTG's NAV distribution rate near 8%. ​
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​The good news is the fund has some flexibility to wait for better results.
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​Around $180 million of unrealized gains were available on UTG's balance sheet as of April. Along with annual NII of $30 to $40 million, the fund's distribution of approximately $170 million could remain covered (without triggering a return of capital) for at least another year even if stock prices dipped a little from here.
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​Management could also choose to use more leverage, which would boost income and (potentially) returns.
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​We will keep an eye on UTG's performance in the quarters ahead. Should the fund's NAV distribution rate continue stretching higher, we would revisit our Dividend Safety Score.
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​For now, UTG still looks like one of the better CEFs based on long-term returns, volatility, and a relatively cheap expense ratio:
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​And unlike some high-quality funds that trade at steep premiums to NAV, UTG shares are trading about in line with NAV. This could reduce risk of a sharp selloff if underlying performance of UTG's portfolio remains underwhelming.

Hopefully this analysis gives you some perspective on how we think about closed-end funds. We'll keep a close eye on UTG and are always here to answer any questions! Thanks for reading.