07th October 2022
Back in mid-September we wrote a blog in which we highlighted the potential vulnerability of real assets (property, infrastructure, shipping etc.) to rising bond yields and outlined why this might be the case. In short, increases in the risk-free rate can, in some instances, lead to higher discount rates and higher debt costs with negative implications for valuations and cashflows respectively. An increase in the yields and returns available from traditional bond markets also raises question marks over the opportunity cost of owning alternative assets. A 4-6% income return from an uncorrelated real asset looks great when Gilts yield less than 1% (as at the start of this year), but less compelling when government bonds are offering 4%.
Our musings proved prescient. Bond yields have been steadily rising all year but catapulted higher on the back of the government’s mini-budget which helped catalyse one of the most aggressive repricing of nominal and real yields in history. In a matter of days, the price of the long-dated (2068) index linked Gilt fell 56%, whilst the 10-year real yield rose by over 150bps in a week. These seismic moves in the bond market inevitably impacted other assets classes and real assets have not been immune with many of the investment trusts that invest in this space de-rating aggressively.
We have been steadily reducing our real assets over the course of this year with our Distribution Fund’s exposure falling from just under 30% in December 2021 to around 20% today. Proceeds from these sales have been rotated primarily into credit but also equities where cheapened valuations have improved return prospects from these more traditional asset classes. As unconstrained, valuation led investors, this evolution in terms of positioning is entirely natural. Despite the targeted reduction however, we still believe that certain real assets have an important role to play in multi-asset funds in terms of both their real return prospects and the portfolio diversification benefits they bring.
One area we remain bullish on is energy storage. As covered in a previous Crescendo, battery storage assets enjoy a secular tailwind in that they are essential to the inexorable roll out of renewable energy. As inherently intermittent wind and solar become a bigger part of the overall energy supply pie, battery storage capacity is required to mitigate risks around resulting supply and demand imbalances. In addition, underlying revenues are uncorrelated and don’t exhibit any economic sensitivity. Tick, tick. In the context of sensitivity to rising bond yields, one of the investment trusts we use to access this space applies a discount rate of 10.8% within its discounted cash flow valuation. We believe this to be high, given the nature of the underlying assets, and certainly offers a significant risk premium capable of absorbing material increases in the risk-free rate. Importantly, history teaches us that discount rates used to value real assets do not move in a linear fashion with changes in government bond yields, whilst we also know that other inputs influencing net asset values (revenue projections, inflation assumptions, tax rates etc.) may well act as positive factors in the months ahead. The energy storage investment trusts we own are conservatively geared and as such should be well insulated from the impact higher short end rates can have on floating debt costs. Finally, there are visible and tangible drivers of capital growth which stem in part from the valuation uplift that occurs when batteries move from being in construction to being operational. To put some numbers around this, Gresham House Energy Storage which we own across our 3 funds, is a 4.3% yielder yet delivered a NAV total return of 27% in the first half of this year. Given visibility on asset progression, we are confident of further capital growth in the future.
This point is crucial. Real asset investment trusts offering a 6% income but limited prospects for capital growth probably aren’t going to cut it in this new world. Those that can deliver attractive total returns over and above those available in government bond and investment grade credit markets should continue to prosper. This, unsurprisingly, is where we are focussed.
Ben Mackie – Fund Manager
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