Infrastructure has been one of a handful of ports in the storm of investment markets over the past 12 months. It has insulated investors against the worst ravages of inflation, protected capital and delivered a reliable income. At least until this week, when it become another casualty of chancellor Kwasi Kwarteng’s mini-budget.
The average infrastructure securities investment trust is up 4.8% over the past 12 months, providing a ballast for portfolios, that may be otherwise nursing double-digit losses. Renewable energy infrastructure trusts have been particularly strong, buoyed by the stronger outlook for renewables. They have seen an average rise of 7.5% and continue to pay a chunky income.
The sector had looked like a safe bet. Almost all developed market governments are looking to solve the problem of poor productivity and slow growth with infrastructure investment. In the US, for example, the Infrastructure Investment and Jobs Act provided $1.2trn in federal spending over the next five years, including $110bn on roads and bridges, and $66bn on railways. Yields of 5%+ and inflation-adjusted cash flows appeared to offer investors a reliable cushion in an uncertain moment.
However, the past two weeks have been grim for infrastructure assets. The average infrastructure securities fund is down 10.8% over one month, while infrastructure funds are down 8.5% and renewable energy infrastructure is down 6.4%. What has prompted this sell off? And is it an opportunity or a warning?
Markets don’t wait
Mick Gilligan, head of managed portfolio services at Killik & Co, says it’s largely to do with rising discount rates in the wake of Kwarteng’s mini budget. He says: “The average discount rate for the HICL Infrastructure portfolio, for example, was 6.8% in the company’s last set of results in June. Another way of looking at this is that if everything goes according to plan – ie based on management assumptions about the income it receives, economic conditions, etc – the portfolio will grow by 6.8% over the next year.
“This discount rate will almost certainly rise by the time of the next company disclosure at the full year results in December, unless we see bond yields reverse dramatically. But markets don’t wait. They adjust prices now.”
All infrastructure funds set out the assumptions they make on the discount rate in arriving at their NAV in their report and accounts. Killik’s research shows that for every 1% increase in the discount rate, investors can expect a decline of between 5.4% and 9.9% in the NAV of these trusts. The least vulnerable appear to be the renewable energy infrastructure trusts, and the most vulnerable are the traditional energy infrastructure trusts such as HICL and International Public Partnerships. This is why these areas have seen the greatest falls in their share prices to date.
But has this been over-played? After all, the discount rate is only one factor in determining the NAV, and the cashflows for many trusts should benefit from rising inflation. Ben Newell, an analyst at Investec, thinks so: “Consideration must also be given to the underlying cashflows of these companies and how these are expected to perform in the prevailing macroeconomic environment. In most cases, we believe that cashflow expectations are likely to have improved in recent months from a combination of factors including higher current and forecast inflation, foreign exchange, UK corporation tax changes and increased deposit rate assumptions.
“The renewables companies will also benefit from elevated spot and forward power prices. In our view, it is important to consider the impact of macro-economic changes on all variables within the valuation model, rather than purely focusing on the discount rate or risk premium.”
What other options are there?
Investec also says that those companies with less exposure to the UK, where government bond market volatility has been highest, and those with riskier assets should fare better. “We believe that the impact on NAVs will not be as extreme as initially feared.”
This is a view echoed by other analysts. At Peel Hunt, Anthony Leatham has crunched the numbers and notes that Sequoia Economic Infrastructure Income Fund stands out for a price return that has overshot the estimated NAV impact. He also highlights SDCL Energy Efficiency Income Trust as having seen a price movement greater than the estimated NAV impact. He adds: “GCP Infrastructure Investments and NextEnergy Solar Fund also trade on some of the widest discounts after the NAV adjustment.”
There are other reasons to believe that the infrastructure sector may work through this latest rout. Some stability appears to be returning to UK government bond markets since the Bank of England’s intervention. The 10-year gilt yield is back below 4%, which has seen share prices for some of the infrastructure trusts revive.
The ‘there-is-no-alternative’ (Tina) trade may also apply. The past week has left UK government bonds a distinctly unattractive option, while equity markets remain volatile. Where else are investors going to source inflation-protected income and diversification if not from infrastructure trusts?
It is not just infrastructure funds that have proved vulnerable. UK commercial property trusts also sold off heavily as government bond yields pushed higher. This too may prove a knee-jerk reaction to a relatively short-term phenomenon. Undoubtedly, discount rates needed to adjust, but as is often the case, they appear to have moved too far too fast and some adjustment is likely to be necessary.
