In most major economies, investors seem quietly confident that inflation has peaked. The proof is in government bond markets, where yields have started to stabilise in the past few months. Until recently, the UK had been a glaring exception.
Earlier this month, the UK sold a bond at auction with an annual return of almost 5.7 per cent – the highest yield recorded in 16 years. Investors were effectively demanding greater returns in anticipation of sticky inflation and further rate hikes by the Bank of England.
Rising gilt (UK government bond) yields have been bad news for listed infrastructure trusts, despite their reputation as safe-haven holdings and in some cases their inflation-linked revenues. This is because an increased rate of return on government bonds – thought to be the most secure of all asset classes – forces discount rates up. This in turn erodes a trust's net asset value (NAV).
Against this backdrop, the average share price total return for London-listed infrastructure funds fell by 3.4 per cent in June. Things were even worse for renewable energy infrastructure trusts, which saw an average drop of 6 per cent over the month. The question is whether NAVs will fall to the levels that share prices still imply. Analysts at Numis don’t seem to think this is likely.
“We believe that discount rates implied by current share prices are too aggressive for the relative risk, and significantly surpass the historic trough discount rates (last seen in 2008),” they wrote in a June note. Current share prices imply discount rates close to 10 per cent in some cases, which Numis says “overstates” the risk to underlying cash flows.
Debt issued by conventional and renewable funds tends to be long-term fixed and hedged at reasonable rates. This means that increasingly expensive debt won’t be a major detriment to earnings. But beyond this there isn’t much for current investors to feel optimistic about – at least in terms of recent performance.
Data from Winterflood indicates only two infrastructure funds delivered a positive share price return in the first half of the year: Riverstone Credit Opportunities Income (RCOI) and Cordiant Digital Infrastructure (CORD). As of the end of last month, both had achieved a 3.2 per cent uptick since January. With gilt yields much higher than they once were, now might seem like an obvious time to retreat into the safety of government-issued debt. If bond proxies look risky, why not just buy the real thing?
This is a question investors will have to weigh up depending on their individual goals. However, contrarians looking for evidence of infrastructure’s resilience don’t have to look far. While many London-listed funds weren’t around last time interest rates were this high, two important ones were: International Public Partnerships (INPP) and HICL Infrastructure (HICL).
Both funds listed in 2006 and have mostly traded on significant premia to NAV ever since. Stifel analysts reasonably theorise that these valuations reflected demand from investors who liked investments with inflation linkage, low correlation with equities and relatively high dividend yields. There are now other funds that have some of these qualities to a greater or lesser degree, but as we noted last week there's also still a case for both HICL and INPP ('Which infrastructure trust should you buy?' IC 14 July 2023).
Recent history shows that inflation can remain persistent for longer than we think, and the Bank of England will keep hiking rates accordingly. Investors don’t have much reason to be cheerful, but the pessimism surrounding infrastructure may be excessive.
