Paying for infrastructure

Advocates of infrastructure trusts include Alan Brierley, director of the investment companies team at Canaccord Genuity. "Listed infrastructure offers attractive risk-adjusted and genuine absolute returns," he says. "Given capital preservation qualities and low correlations with other asset classes, it has a clear role within strategic asset allocation. Strong demand for attractive, sustainable and growing dividends, with underlying cash flows underpinned by long-term contracts with the public sector have been key drivers of the sector's evolution."

The trusts investing in Public Private Partnerships (PPP) typically have concessions with average tenures in excess of 20 years.

"These income characteristics have significant value in a lower for longer environment," he adds. "We expect the power of compounding attractive returns to continue to deliver superior long-term returns with relatively low volatility."

The cash flows have a high degree of inflation linkage, unlike corporate bond funds, although this varies from trust to trust. "These characteristics have obvious appeal for investors searching for income and or those looking to meet long-term liabilities," says Mr Brierley.

The yields are also typically higher than corporate bond funds.

"All investors can benefit from these funds because they take different degrees of risk with some globally, and some UK focused," adds Jane Heyman, chartered financial planner at McCarthy Taylor. "All portfolios need something steady with a good dividend yield. These are attractive for cautious investors looking for dividends and income, and if markets are not doing much then the dividends can be reinvested, making them suitable for both growth and income investors."

Infrastructure investment trusts can diversify portfolios because their correlation with the FTSE All-Share is just 0.12 per cent, while since March 2006 the sector has delivered a shareholder total return of 95 per cent against 58 for the All-Share with only two-thirds of the volatility.

They can provide downside protection in turbulent markets: in 2008, for example, when the All-Share plunged around 30 per cent, IC Top 100 Fund HICL Infrastructure (HICL) made a positive share price return of 5 per cent. Sector peer 3i Infrastructure's (3IN) share price fell a lot less than the All-Share - 18 per cent - and its NAV made a double-digit positive return of 13.22 per cent.

Mr Brierley also points out that during the sell-off in the third quarter of 2011, which resulted in a peak-to-trough All-Share fall of 19 per cent, the listed infrastructure shareholder total return only fell 3 per cent.

He also argues that at this time in the market cycle, with things having done well, it may be time to lock in some exceptional gains for equities and move to safer investments such as infrastructure.

Also see why investors are turning to cash

Infrastructure investment trusts are the only way for private investors to get exposure to direct invest in this asset, because to put money into projects themselves you need to be a large institution with millions of pounds to invest.

Infrastructure investment trusts

Source: Morningstar

Performance data as at 1 August 2014

High price

Because of their attractive attributes infrastructure investment trusts have traded on high premiums to NAV for years. If you buy something overvalued it is likely you won't make as much money on it, according to Mick Gilligan, head of research at broker Killik, and you haven't got as much margin of safety if things go against you.

"While we acknowledge the attractiveness of the asset class given its security of income, yield spread over equal-maturity treasuries and high single-digit total returns, we do not believe investors should be paying in excess of a low single-digit percentage premium to prevailing NAV to access the asset class," add analysts at Liberum.

But if you hold the investment trust for the long term, a premium to NAV is not such a problem as its good returns may compensate for this over time. If you don't expect the premium on the trust to narrow any time soon because it has been fairly constant, you may also be able to sell it at a premium.

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If interest rates rise, then the income level infrastructure trusts offer will not seem so attractive and their shares may become less popular, causing a fall in the premium to NAV.

But Mr Brierley argues: "We believe that fears of materially higher rates are misplaced. It is difficult to envisage a scenario which would lead to a material rate increase or a return to pre-crisis levels. (Bank of England governor) Mark Carney recently forecast that UK rates would stabilise around 2.5 per cent in 2017, a level which is half pre-crisis levels…[and] we would highlight the embedded inflation protection in the cash flows."

Mr Gilligan says that if interest rates rise then it is likely inflation will, too, and as some of these funds' revenues are inflation linked this could mitigate the effect of rising interest rates. "But these would not do well in an environment where interest rates rise and inflation doesn't," he says.

Giles Frost, manager of International Public Partnerships (INPP) infrastructure trusts assets should keep investors interested because of their reliable long-term income stream, while, Tony Roper, manager of HICL Infrastructure, says that these trusts would seem less attractive if interest rates rise to 7 or 8 per cent, but he does not expect them to rise to these levels.

Pricy assets

Ms Heyman points out that you may be able to buy shares in one of these trusts at a lower premium via a 'C' share issue, especially if you are an existing investor. However, because the infrastructure investment trusts have had difficulty finding assets they are generally not looking to do 'C' share issues in the short term, especially because if a fund has a lot of cash it can be a drag on performance. But not doing issues will make it harder for them to bring down their premiums to NAV and grow the fund size.

Many funds and investors are competing for infrastructure assets, driving up prices, and there has also been a reduction in the number of private finance initiative (PFI) and PPP projects coming to market.

"The challenge facing all managers is investing in quality assets at the right price," says Mr Brierley. "Experienced managers with broad and long-established relationships with potential vendors and developers have a key competitive advantage."

Where possible, HICL has been sourcing opportunities direct from sellers rather than intermediaries and has built up relationships with a number of the parties involved. It has also started investing abroad - for example, recently buying a 5.85 per cent stake in the AquaSure PPP project in Melbourne for £47m, its first investment in Australia.

It also expects to buy out more shareholders in the UK on projects where it has a partial stake.

Read our interview with HICL's manager

HICL says that if this level of demand continues in the UK, pricing may become so expensive that it will not be possible to generate the required net returns from new investments but it does not need new investments to meet its investment targets.

International Public Partnerships has also been buying less over the last two years, and selling assets because you can get such a good price, a recent example being its holding in the Medicast SAS Amiens hospital PPP project in France.

But it has also been buying assets directly off developers and creating assets itself, such as putting capital into new schools being developed under PF2 (the successor to PFI and PPP).

Doing this introduces operational risk, although Mr Frost argues that the history of these schemes in the UK has shown success in delivering projects, and says they choose better capitalised construction companies which are theoretically less likely to become insolvent.

International Public Partnerships is also investing in new areas such as transmission lines to offshore wind farms. "This is very successful and, although it is not a PFI or PF2 scheme, has a similar risk profile," he says.

Other risks

In rising markets infrastructure investment trusts can lag the broader market, and this could be compounded if investors switch out of these funds into higher-growth investments.

Even if these trust's assets are performing well because they are listed on the stock market their share prices could go down with the market.

Many of the trusts with the exception of HICL, 3i Infrastructure (3IN) and International Public Partnerships are relatively new, so they don't have long-term track records to assess.

Trusts invested in overseas markets, particularly emerging markets, may face political risk or problems with corporate governance, as well as differences in tax, inflation, contracts and legal issues, which could create risk. They also face foreign-exchange risk.

Clients and key subcontractors are important counterparties and a potential risk, although trusts such as HICL have a diversified range of facilities management contractors to spread the counterparty risk.

Governments may renege or change historical contracts, although this is not considered a high risk in the UK. HICL adds that this is probably lower when governments are also seeking further private sector capital to meet new infrastructure spending.

Funds

Ms Heyman says you could put around to 5 per cent of your assets in infrastructure investment trusts.

Rob Jones, an analyst at Liberum, says when you choose an infrastructure investment trust you should be aware of what its underlying assets are as they all have slightly different exposures. "For example, GCP Infrastructure (GCP) offers a slightly higher yield but its underlying assets are arguably higher risk," he says. "You should understand what the assets are and what their risk is."

Mr Brierley rates GCP as a buy. This is the only infrastructure investment trust mainly focused on debt and has the highest dividend yield. It has a diversified portfolio with around 40 per cent in PFI, 26 per cent in rooftop solar and 11 per cent in onshore wind. But it gives exposure to some higher-risk investments.

He also rates IC Top 100 Fund HICL Infrastructure as a buy, which has a progressive dividend policy and expects to pay 7.25p for its year to 31 March 2015. The company is the oldest and has experienced managers, but trades at a premium to NAV of about 17 per cent.

Ms Heyman likes John Laing Infrastructure (JLIF) because it has access to its asset manager, John Laing's projects. "This takes away the cash drag risk," she says.

Mr Brierley also rates this as a buy. It focuses on PPP infrastructure in developed markets but has recently changed its investment policy to be able to put up to 30 per cent of its assets in construction. This raises the risk profile but offers more potential opportunities.

Mr Gilligan likes 3i Infrastructure because it has a variety of assets rather than being focused on PFI schemes, and owns some of its assets outright rather than having a concession. It is also large with a market capitalisation of £1.2bn and is therefore easy to buy and sell. But while 3i Infrastructure offers potential for more capital growth over time it is more volatile than the PFI-focused funds and has a concentrated portfolio - for example, nearly a quarter of its assets are in Anglian Water.