Should I stay or should I go?

 
Source: JPMorgan Cazenove
 
Now the genie of higher rates is out of the bottle, it is not surprising that there has been an unseemly scramble to leave the alternative income party, and join the (rather more staid) bond party next door as shown in the graph below. Maybe it’s less a party and more of a tea dance.
 

 
Many investors might be left wondering what the prospects are for these alternative income trusts. Do current discounts accurately reflect prospects for this diverse set of trusts?

Certainly, those trusts that are sensitive to the economic cycle and have high leverage may suffer from a hard economic landing. Commercial property may be vulnerable in a significant recession, and with leverage forming a significant part of the capital structure – across the commercial property industry, not just investment trusts and REITs – there are clearly headwinds the sector faces from re-adjusting to the new higher interest rate environment.

Over time rent from property grows, and although UK leases don’t tend to have inflation indexation, there is a long-term correlation with inflation. We examined the case for wide discounts in this article, but in order to see discounts narrow, we believe we need to see rental growth coming through strongly, or gilt yields falling.

Music royalty trusts (of which there are two) have suffered from sector-specific issues, in our view related mainly to a lack of investor understanding of the asset class. Discounts for both trusts are very wide, and it is possible that the trusts in the sector need to shrink first before they can grow, proving their portfolio valuations and de-leveraging, as well as creating rarity value for their shares.

As regards the infrastructure and renewable energy infrastructure sectors – which constitute 85% of the £38bn of net assets in the table above, one can credibly argue that these trusts have low economic sensitivity, yet now trade on significantly wide discounts.

The more established trusts within these sectors tend to have highly diversified portfolios, which means that aside from asset class risk, there are few specific risks. The advantage of well-established portfolios with breadth of exposure is that it allows managers to continue to add accretive investments (either through selling other investments or through reinvestment of surplus cashflow) at attractive returns, without significantly skewing the overall risks of the portfolio.

Examples include HICL Infrastructure (HICL) which has been repositioning the portfolio away from PPP assets (which are a well-understood investment class within infrastructure, and attract highly competitive prices when sold) into less well-understood investments which have a higher correlation to inflation and offer longer-term cashflows.

A recent example within HICL’s portfolio is Fortysouth, which represents the passive infrastructure of Vodafone New Zealand, including the physical towers, masts, and poles. The asset has an availability-based contract with Vodafone NZ for an initial 20-year term, with the option of two ten-year extensions and revenues are inflation-linked and unrelated to usage.

It is through investments like these that HICL’s managers aim to build out HICL’s earnings base long into the future, such that the weighted average life of the portfolio has increased from 21 years to 32 years since 2015.
 

Relative returns remain attractive

 
This brings us to one of our main observations, which is that whilst the attractions of short-term bonds have significantly increased this year, the yields on offer at the longer end of the curve, which are much more comparable to infrastructure and renewable energy infrastructure trusts, have moved significantly less far. In the graph below, we illustrate the fact that over six months to 30 June 2023, it is short-term interest rate expectations that have risen the most dramatically. On a ten-year maturity, gilt yields have risen by only 56bps over the first half of the calendar year, and since the end of June have actually stepped back a small amount to 4.24% (as of 28/07/2023).
 

 
Bond GRYs show the IRR if held to redemption. How do infrastructure and renewable energy trust IRRs compare? Helpfully, infrastructure and renewable energy infrastructure trusts publish their portfolio’s weighted average discount rates periodically.

Discount rates (not to be confused with share price discounts to NAV) represent the expected long-term total returns, or IRR, from the portfolio of assets based on a number of long-term assumptions. Investors need to adjust this discount rate (which is gross), deduct the annual ongoing charges, and adjust for the effect of any trust level gearing and interest costs to arrive at estimated NAV total returns.

For example BBGI Global Infrastructure (BBGI), which sits at the lower risk end of the listed infrastructure peer group, has a last published portfolio discount rate of 6.9% (as of 31/12/2022) and an OCF of 0.87. The fact that BBGI has no expectation of trust level gearing over the long term makes the calculation simple.

We deduct the OCF from the portfolio discount rate to get to the expected NAV IRR of 6.03%. We note that this return is very far from guaranteed. Firstly, achieving this IRR requires that operationally all of the assets perform as expected and that there are no changes to underlying assumptions.

Secondly, comparing IRRs between trusts only makes sense if the underlying assumptions are all the same: unfortunately, trusts do not spell out in detail all of their assumptions, so the best that anyone can do is estimate how these assumptions differ.

Finally, we would note that trusts release NAVs and discount rate information at different times. For example, TRIG – Renewables Infrastructure Group (TRIG) has very recently released an increased portfolio discount rate of 7.9% as of 30/06/2023 (up from 7.2% six months ago), whilst HICL’s latest discount rate is as of 31/03/2023.

HICL has announced in a trading update that it expects the discount rate to increase when it reports a NAV as of 30/09/2023, but that the negative effect on the NAV will be materially offset by the impact of higher or actual inflation.

We show below the latest published discount rates for the main trusts in the sector. As we noted above, each trust is subject to different risks and underlying assumptions, and several trusts may yet increase their discount rates.

Differing underlying assumptions mean that the IRRs in the table below are not exactly comparable but represent a ballpark illustration of prospective returns. Additionally, for those with trust level gearing, returns may be higher still.

For example, Greencoat UK Wind (UKW) spelt out the difference between its unlevered discount rate (which we reproduce below) and the levered discount rate of 11% (and a NAV IRR of c 10%), which assumes current levels of gearing are maintained into the future.

UKW is currently geared 36% on a gross assets basis, or c. 50% on a NAV basis. Hence the higher prospective IRR than the 8.1% prospective IRR we show in the table below, which represents potential upside.

We would point out that these extra returns do not of course come without extra risks, which include refinancing risk. Trusts which invest in levered assets through SPVs, usually have fixed interest rates within these structures over the life of the subsidy regime, and also repay this debt over the same period.

Currently, with share prices below NAVs, if logic has anything to do with it the market is clearly applying either higher discount rates, expecting lower power prices, or lower inflation than assumed by these trusts.

We note that the IRRs below, without accounting for trust level gearing, look attractive in the context of long-term equity returns, and note that historically these returns have been achieved with significantly lower volatility than equity markets exhibit. One might hope for discounts to narrow over any holding period, further adding to prospective returns.
 

Discount rates and prospective NAV NAV IRRS as of 04/08/2023