The siren song of high yields has lured many an income investor onto the rocky shoals of dividend cuts and permanent capital losses.

Indeed, over the years, we’ve chatted with investors who have allocated 25% or more of their portfolios to high-yield securities. That’s just playing with fire.

That doesn’t mean you should shy away from high yields entirely. But high yielders shouldn’t occupy an outsize role in your portfolio.

At Investing Daily’s Utility Forecaster, we primarily focus on stocks whose yields range from 3% to 5%. But we do dabble in the high-yield space a bit too.

When we screen for high-yield securities, we’re generally trying to find the least-risky stocks in what can be a pretty risky space. Unfortunately, a lot of seemingly promising ideas fail to pass muster upon closer inspection.

But there is another way to get a high yield without necessarily blowing up your portfolio. It involves a leveraged play on some of the least-risky stocks in the market. In other words, it’s a managed risk.

Managed Risk

Although we’re primarily a stock-picking service, we also periodically write about funds. One of our longtime favorites is Reaves Utility Income Fund (NYSE: UTG), a closed-end fund that currently yields 6.6% and trades at an 8.4% discount to its net asset value.

Although closed-end funds (CEFs) have existed for more than 120 years, most retail investors haven’t heard of them.

While these securities may occupy an obscure corner of the market, they have a lot in common with mutual funds and exchange-traded funds (ETFs). In fact, they’re somewhat like a hybrid of these two better-known securities.  

Like mutual funds, CEFs are actively managed pools of assets.

Unlike mutual funds, which can create an infinite number of shares to accommodate investor inflows, a CEF’s share count is generally fixed. Its shares outstanding only change if the fund buys back shares or issues more of them to raise capital.

Like ETFs, CEFs trade on public exchanges.

Together, these attributes can cause a CEF’s share price to dip below the net asset value per share of its portfolio. And that gives value-oriented investors such as ourselves an opportunity to buy a stake in a portfolio at a discount to its current market value.

Reaves focuses on the same essential-services companies that we do: electric, gas, telecom, and water utilities, along with a few midstream master limited partnerships (MLPs).

The Risk Factor

Now you’re probably wondering how Reaves can offer a distribution that yields 6.6% even though it specializes in selecting stocks that generally yield in the 3% to 5% range.

And that brings us to the primary risk factor. Reaves uses leverage to enhance its yield, which means it borrows money to expand the size of its portfolio. Right now, for instance, the fund has a leverage ratio of nearly 23%, which means that for every $1 of investable capital, $0.23 is derived from borrowing.

During bullish periods this leverage can boost gains. But during bearish periods, it can magnify losses. In the bear market year of 2008, for example, Reaves’ net asset value dropped nearly 43%, or about 14 percentage points worse than the average utility.

The Dreaded Return of Capital

One of the things we like about Reaves is that unlike many of its CEF peers, it doesn’t engage in destructive returns of capital (ROC).

By contrast, some high-yield CEFs maintain their distributions simply by giving investors their own money back net of management fees via return of capital, which can be destructive to shareholder value.

The fund did cause a bit of consternation late last year when an estimate of the sources of its payout characterized a substantial portion of one month’s distribution as return of capital. At the time, management attributed that to timing issues, where the scheduled monthly payout isn’t always in synch with the receipt of investment income and the harvesting of capital gains.

Furthermore, they said they expected ROC’s contribution to the annualized payout to diminish or possibly even disappear entirely as the fiscal year progressed.

Indeed, the latest monthly filing that shows a summary of Reaves’ cumulative distributions for its recently ended fiscal year shows that ROC now accounts for just 2.6% of the annualized payout. And it’s possible that in the official accounting, it may end up going away entirely.

Other Doubts Addressed

Reaves didn’t help matters when shortly thereafter it decided to do a rights offering to raise capital—only the second such offering in the fund’s history.

The issuance resulted in the creation of 5.3 million shares, which was equivalent to about 18.3% of the fund’s shares outstanding. However, that move also raised more questions about the sustainability of its distribution.

The fund said it intended to use the proceeds from the offering to take advantage of the selloff in the utilities space due to rising-rate fears, while also looking for opportunities to pick up high-quality energy stocks reeling from the extreme dislocation in the energy sector.

Management’s timing turned out to be pretty good—the offering closed last December when utilities were limping into the year’s end and the energy sector was just a couple months away from its final capitulation.

Meanwhile, other investors have raised concerns about the fact that a substantial percentage of the fund’s annualized payout has been sourced from long-term capital gains over the past two years, instead of net investment income.

Here, again, we think there’s a reasonable explanation. Although utilities ended 2015 slightly in the red, the sector had hit an all-time high earlier that year. So it makes sense that management would be using that as an opportunity to lock in capital gains.

Similarly, utilities had a pretty incredible run during the first six months of 2016, hitting new all-time highs that strained credulity in terms of valuations. So management absolutely should have used that as an opportunity to cash out of longtime holdings.

Nevertheless, when it comes to high yielders, even our favorites, it’s good to keep a close eye on such developments and apply an appropriate level of scrutiny.

Fortunately, Reaves has taken full advantage of this year’s market dynamics. On a year-to-date basis, the fund has delivered a total return of 18.7%, compared to 9.8% for the broad market and 10.5% for the utilities sector.

It’s possible that utilities could get rocked harder by the inflation trade. But Reaves is trading at a current discount to net asset value that exceeds its longer-term average, which makes it a compelling buy at current prices.