Get real

The prospect of attractive real returns seems to be ignored by the market…by William Heathcoat Amory

 
It’s fair to say that many investors’ interest in infrastructure was originally piqued by the long era of low interest rates, and the phrase “bond proxies” was very often applied to infrastructure trusts. The other characteristic of infrastructure that seemed a ‘nice to have’ back when inflation was only something your parents talked about, is that it very often has explicit contractual links to inflation. In today’s world, this is potentially a very valuable feature.

In the context of the wide discounts currently found across the infrastructure and renewable infrastructure sectors, we think the catalyst for discounts closing seems more likely to be investors’ better recognition of these trusts’ ability to be sources of real returns. In the meantime, the value on offer is eyepopping. BBGI Global Infrastructure (BBGI), arguably the least risky trust in terms of revenues given it is 100% invested in availability-based assets, trades on a discount to NAV of 9.4%, compared to a low teen’s premium not so long ago. HICL Infrastructure (HICL), which invests in a broader range of infrastructure assets, trades on a 25% discount to NAV. Certainly, with HICL’s dividend having been held for a number of years, investors who expected a more direct impact from rising inflation on the distribution, may have been disappointed. As we discuss in our last note HICL’s manager has been rebalancing away from PPP assets to capture longer-term cash flows with greater growth and/or inflation linkage, which tend to initially provide lower yields. There is a case to be made that HICL shareholders are forgoing jam today in order to build the foundations of future dividend growth, long into the future.

On the other hand, Greencoat UK Wind (UKW) has explicitly linked the dividend to inflation, yet trades on a discount to NAV of 17%. As with all of these trusts, there are plenty of moving parts and assumptions baked into the NAV. However, UKW provided a lot of clarity on dividend cover in various scenarios at its last results, which we show below, which should give investors reassurance in our view. When it comes to capital values – UKW’s levered discount rate is now 11% – a hefty premium above gilts, and implying a NAV total return net of management fees of 10% per annum. UKW has the highest discount rate in the sector. The link with inflation, as well as its characteristics as being a relatively low volatility investment, mean this return over the long term – if achieved – would be very attractive on an absolute and risk adjusted basis. In our view, that investors receive a decent proportion of the total returns through a dividend, also de-risks the proposition. Clearly much could change – the main risks would be if a) inflation is much lower than the market is currently forecasting, or b) the price of electricity (itself a derivative of the gas price) fell more quickly than is currently expected or c) the government retrospectively changes subsidy regimes for wind turbines. Once the market’s fears on further rate rises dissipate, we think UKW could see a re-rating, and certainly if bond yields fall once again.

Source: Schroders Greencoat, All numbers illustrative. Power prices real 2022, pre PPA discounts
Past performance is not a reliable indicator of future results
 
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Disclaimer

Disclosure – Non-substantive Research

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. With this commentary, Kepler Partners LLP does not intend to influence your investment firm’s behaviour.