A safe long- term bet for our investment-trust income portfolio

Utilities make sense if you’re looking for income, says David Stevenson. But regulators and politicians can ruin the attractions. Make sure you diversify your holdings.

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Ecofin is a latecomer to the benefits of renewable power

Utilities make sense if you're building an income portfolio, but regulators and politicians can ruin the attractions. Make sure you diversify your holdings.

This week I have another idea for our income portfolios (see below). Big electricity and energy utilities are boring dividend plays, with heavily regulated core assets subject to rules that only let them raise prices by a formula based on inflation rates. These steady income streams encourage firms to take on more debt because the cash flows are so predictable, financial engineers can ladle on low-cost debt to leverage returns. Thus, dividend yields on utility stocks such as SSE can be more than 5% in a good year.

However, picking stocks individually involves real risks. The obvious one is execution risk when management invests in the wrong thing and the share price reacts negatively. There's also policy risk especially in the UK, where politicians love to suggest price caps and some even threaten renationalisation. Globally there's regulatory risk, powered by that political displeasure the formulas that set prices can be amended by administrative fiat, cutting profit margins.

So, in these circumstances it's probably best to invest in a diversified fund that invests across geographies, sectors and size (small and large cap). Ecofin Global Utilities and Infrastructure Trust (LSE: EGL) is one of the longest-established utility funds in this space and has been on the UK market for the last few decades. It was originally a split-capital vehicle with zero-dividend, income and capital shares. The shares crashed after the split-caps crisis in the early 2000s, then rebounded. But for much of the past decade the shares drifted sideways, despite paying a generous yield.

A new, more exciting Ecofin

In 2016, the fund was restructured, with some assets put into run-down, and relisted as a reshaped utilities and infrastructure vehicle. One could say it has been unlucky in coming late to the exciting party in renewables and infrastructure for many years, the fund was more focused on conservative utility businesses.

However, realising the error of its ways, it decided to refocus on renewable power, yieldcos and infrastructure.Big holdings now include NextEra, a US-focused renewables yieldco, as well as Finnish outfit Fortum and Spanish renewables giant Iberdrola. The fund's net gearing (use of borrowed money) has also been increased, to 17% of net assets.

All of this seems to have worked in the first year of the newly reshaped fund, which has delivered net-asset-value (NAV) and share-price total returns of 14.5% and 27.7% respectively significantly outperforming the MSCI World Utilities index's 3.8%. Ecofin is currently producing a portfolio yield of around 5.7%, and the companies in the portfolio are expected to grow their dividends at a compound rate of 6.5% per annum through to 2020. That sounds ambitious, but data from Goldman Sachs suggests that net income for the sector is expected to grow at a compound 8% per annum, and by 25% cumulatively through to 2020. Meanwhile, price/earnings valuations for US and European utilities are extremely low by historic standards.

However, investors are now fretting about higher interest rates, since rising debt costs could spell trouble not least because utilities have borrowed so much money. And political risks powered by worries about living costs for customers have undermined sentiment. Hence shares in Ecofin are down 15.7% over the past quarter, while the discount of the fund is currently sitting at 15%.

I think the share price could yet drift lower until all fears are priced in, but you should be able to pick up a well-backed dividend yield of closer to 6% if you buy at the right price. I don't think it is a screaming short-term buy, but it looks a safe long-term hold for income investors.

What we have tipped so far

FundTickerIssueDatePortfolioLatest yield
CQS New City High YieldLSE: NCYF86827/10/17Both7.2%
Gravis Clean EnergyClass C87301/12/17BothTarget 4.5%
Sequoia Economic InfrastructureLSE: SEQI87705/01/18Adventurous5.5%
MedicXLSE: MXF87705/01/18Adventurous7.5%
HICL InfrastructureLSE: HICL88209/02/18Cautious5.4%
Ecofin Global Utiliesand InfrastructureLSE: EGL89327/04/18Both5.2%

My previous picks include CQS New City High Yield, which holds bonds, shares and preference shares; Gravis Clean Energy, which invests in renewables; infrastructure-debt fund Sequoia Economic Infrastructure; medical-facilities fund MedicX; and HICL, which backs public-sector infrastructure.

Our investment strategy

The two portfolios I have been building on this page in previous issues are intended to deliver a robust, growing income (although both come with risks and are not a substitute for cash). The balanced or cautious portfolio aims to deliver a yield of 4.5%, with underlying investments yielding in a range from 3.5% to 5.5%. This portfolio features more mainstream investments, and most of them should be relatively liquid. The adventurous portfolio, on the other hand, will target a yield of 5.5%, with underlying investment yields in a range from 4.5% to 6.5%. These will be more likely to include complex funds or individual corporate and retail bonds. These investments will often have higher bid/offer spreads and be less liquid.

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