Investment trusts, discount rates and interest rates

What looks cheap today might be expensive tomorrow

Recently a note arrived in my inbox from analysts at Peel Hunt looking at the impact of higher interest rates on UK-listed infrastructure investment trusts.

These trusts have been great investments over the past decade, generating reliable income streams from hard assets in a low-interest rate environment. They're also relatively easy to value from an investor perspective, publishing a net asset value every six months (or more), which investors can use to assess whether the stock is over or undervalued.

These net asset values rely heavily on present value calculations that, in turn, depend on discount rates. The lower the discount rate, the higher the present value of future cash flows, the higher the discount rate.

However, with interest rates now back at levels not seen since the financial crisis and it looking as if they're going to stay there, uncertainty is building around the value of assets.

What's more, there's growing competition for capital. Over the past decade, these trusts have had no problem issuing new shares to fund the acquisition of assets as they have tended to trade at a premium to NAV - in a zero-interest rate environment, investors were happy to pay a slight premium to buy a relatively secure 3% dividend yield. But now it's possible to earn 5% risk-free, these trusts have fallen out of favour. In most cases, they're now trading at a discount to NAV and that key equity funding source has been shut off.

Peel Hunt reckons higher rates are also going to put pressure on portfolio valuations. The report points to the fact many investment trusts are still using discount rates in the 1% to 2% range when they should be closer to 4% to 5%.

On this basis, more than half of the infrastructure investment trusts in Peel Hunt's universe could see double-digit nav adjustments to the downside.

Cheap or expensive?

A good example is Greencoat UK Wind. The trust is currently trading at a 16% discount to last reported NAV. That looks cheap. However, the discount almost disappears when its portfolio of wind farms is valued using an up-to-date discount rate. According to Peel Hunt, the trusts that could see the largest NAV impacts due to higher discount rates are HICL Infrastructure, International Public Partnerships and Digital 9 Infrastructure.

The current environment and uncertainty are a good reminder - reported asset values are often unreliable.

An asset is only ever worth as much as another party is willing to pay. As I noted in my previous blog on REITs, it's cash flow that really matters. Inflation-linked cash flows provide a benchmark investors, and analysts can use to value an asset when other price-discovery mechanisms are broken.

In the case of hard asset infrastructure investment trusts, investors can look at the company's underlying investment portfolio and dividend commitments. As the Peel Hunt report notes, "Dividend growth will be an increasingly important differentiating factor for listed infrastructure strategies…particularly where companies have marketed themselves on the basis of explicitly or implicitly inflation-linked revenues."

So what's the takeaway from all of this?

The main lesson is that investors should always view reported asset values, whether property, plant, financial or otherwise, with a degree of scepticism. When the mood changes, there's no guarantee these assets will ever be worth what someone thinks they might be worth.

Second, higher interest rates are leading to more competition for capital, and that's already impacting the ability of businesses to raise equity funding. There's no guarantee businesses that relied on this avenue in the past will be able to continue to do so in the new rate environment.

Third, things that look cheap today might not be in six months' time as the market adjusts to higher rates. As Peel Hunt's research shows, higher discount rates are not yet reflected in trusts' NAV calculations, but that will change over the next 12 months as companies progress through the valuation process and we get more visibility on where the market value of these assets stands in the new rate environment.

After 15 years of ultra-low interest rates, it'll take some time for the market to adjust to the new normal. Investors need to take that into account when reviewing opportunities.