16th September 2022
In past Crescendos we have written a fair bit about our Fund’s significant allocation to real assets; things like battery storage, infrastructure and niche property sectors which, in a world of depressed fixed income yields, have enabled us to access positive real returns. This has been important, given the over-riding objective of our Funds is to deliver positive through the cycle returns after the impact of all costs and inflation. Our focus in the real asset space has tended to be on underlying assets that exhibit low economic sensitivity and that possess well defined, predictable cash flows. Many have delivered double digit NAV returns and have proven to be good portfolio diversifiers in the difficult market environment that has characterised 2022 so far. Our YTD outperformance whilst in part due to our low starting exposure to hard hit government bonds and US equities, has also undoubtably been helped by our material exposure to these alternatives where net asset values have been incredibly resilient.
An aggressive sell off in the bond market has roiled most other asset classes and the alternatives investment trust sector has not been immune, with rising yields impacting real asset investments in a number of ways. Firstly, most of the real assets that we own are valued using a discounted cash flow model, whereby future anticipated revenues are bought back to present value by way of a discount rate. The discount rate is a function of the risk-free rate and an appropriate risk premium to reflect the nature of the underlying assets. Clearly as the risk-free rate increases, there is the potential for the discount rate that is used to value our real assets to also increase. All else equal, a higher discount rate means lower capital values and a lower NAV.
Most investment trusts in the real asset space make some use of gearing to boost returns. Suffice to say we’re very wary of financial engineering and keep a close eye on ensuring that the level of leverage is appropriate to the underlying assets. Higher rates in this regard have the potential to increase debt costs or to heighten refinancing risk. This is particularly the case where the debt is floating or where the debt maturity profile is short in nature. Higher debt costs, inevitably squeeze the cash flows generated by the assets and can impact dividend cover and sustainability.
The third way in which higher bond yields can impact real assets is via the opportunity cost or competition for capital channel. An 8-10% total return from an uncorrelated real asset looks especially attractive when government bonds are yielding 1.0% and corporate bonds 2.5%, but they are a little less compelling when it’s possible to get an 11.5% yield to maturity (YTM) from a nimble, actively managed investment grade credit fund.
Our answers to the quandary posed by the implicit link between bond yields and real assets are threefold and address each of the impacts outlined above. Firstly, focus on alternative investments where the discount rate offers a margin of safety, or put in other words where the risk premia component is large enough to absorb a material upwards move in the risk-free rate. We also focus on assets where expected revenue or rental growth should be sufficient to offset outward moves in discount rates (or cap rates for property) helping sustain attractive NAV total returns. It’s also worth noting that some real assets (renewable infrastructure, some property leases) enjoy explicit indexation and will see cash flows benefit from higher inflation, which, given the typically positive correlation between higher inflation and higher yields, can act as a natural offset to the impact of those higher bond yields.
On the debt front, a focus on those trusts with fixed term debt or interest rate hedges in place can mitigate much of the risks associated with higher rates.
Finally, as cheapening valuations improve the return prospects of other more mainstream asset classes it is natural that we would consider increasing our exposure to these areas. This is exactly what we have been doing, trimming some of our real asset investment trusts, particularly those trading on extended premia, and gently adding to targeted equity and credit markets as value emerges. With some of the bond funds we have been buying of late offering YTMs in the 12-14% range, our confidence in these nominal assets delivering positive real returns over the medium term despite the lack of indexation has increased measurably.
This is an incremental process however and we are certainly not throwing the baby out with the bath water. We retain significant exposure to real assets within our Funds and continue to champion the return and diversification benefits they bring to a multi-asset portfolio. Adopting a more selective approach in this environment is, however, more important than ever.
Ben Mackie – Fund Manager
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