In an equity income drought, turn to alternative sources to stay afloat

Secure income sources are on shaky ground in the wake of the pandemic. David Prosser explores shifting terrain and suggests investment trust investors tread carefully in the search for yield.

If necessity is the mother of invention, the investment trust industry has really stepped up to the plate.

For more than a decade now, ultra-loose monetary policy has starved investors of meaningful, dependable income. But with banks and building societies offering negative real interest rates, investment trusts have stepped into the breach, raising billions of pounds for exposure to income-generating assets such as infrastructure, real estate, debt and other ‘alternatives’.

The Covid-19 pandemic is driving demand for these investment companies to new levels. With even the most stalwart dividend-paying businesses forced to cut or abandon distributions amid the impacts of the virus, investors who have been depending on equities for income increasingly find themselves in the same position as those for whom interest payments on savings all but disappeared several years ago.

Against this backdrop, many alternative asset trusts have proved resilient during the stock market turmoil of recent months. Shares in the typical infrastructure fund were trading at a premium of more than 10% to the value of the underlying assets in June. In the renewable energy infrastructure sector, average premiums are above 13%.

- Income via social infrastructure trusts appeals in uncertain markets

However, are alternative assets really the safe haven so often portrayed? Investors and analysts alike are attracted to these trusts by perceptions that they are grounded in physical assets, that they offer protected streams of income, and that returns tend to be lowly correlated with stock market performance. But perceptions can be misleading.

“The landscape has changed in recent months and many assets that were thought to have dependable income streams have seen dividend cuts,” warns Ewan Lovett-Turner, director of investment companies research at Numis Securities. “Numerous property, asset leasing and specialist debt investment companies have suspended or reduced dividends, reflecting actual or expected reductions in cash flows. There remains the threat of further dividend cuts in these sectors and it is unclear when and at what level dividends will be restored.”

Dividend cuts

Monica Tepes, head of investment companies research at finnCap, is also concerned. “If you are looking for as much certainty as possible that your dividends are not going to be cut, I think you need to look at sectors where either the local or state government is your counterparty, or your payments come from businesses which are unaffected or even benefit from the current environment,” she says.

“In the first category I can only put infrastructure equity, infrastructure debt and supported living. In the second, I think there are no clear winning sectors – certain players in the logistics sectors seem to be in the right assets, but others aren’t.”

In other words, tread carefully – not all alternative assets are the same. In the debt sector, for example, some trusts will now be heavily exposed to rising defaults. “Many constituents had over-promised and under-delivered even in a benign credit environment before the onset of the pandemic,” warns Alan Brierley, director of investment companies research at Investec. “Here, stock selection is even more critical.”

In the infrastructure sector, meanwhile, some trusts are heavily invested in large state-backed projects with governments standing behind them, or at least in public-private partnerships that effectively benefit from some form of sovereign backing. Others have more exposure to private sector-led projects, where the risks may be higher in certain industries.

In the latter category, Mick Gilligan picks out 3i Infrastructure as a potential cause for concern. “It has exposure to economic infrastructure plays in transport and oil and gas,” Gilligan points out, though he praises the company as well-managed and likely to rebound over the longer term. Renewable energy infrastructure trusts are also worrying some analysts, with the pandemic accelerating the decline in power prices (see below). The key for investors in the coming months – both new investors coming to these sectors in search of income and those with existing holdings – is therefore going to be understanding what these trusts actually hold.

Social housing is one area interesting many analysts, given that this is the only type of real estate investment where the public purse supports rents; this should provide important insulation. “There is an acute shortage of supported housing in the UK and demand is projected to rise as a result of an expanding and ageing population, medical improvements and healthcare policy,” points out Conor Finn, an investment fund analyst at Liberum. “We believe the social housing real estate investment trusts offer the prospect of long-term, uninterrupted income.” He picks out Civitas Social Housing as a good example, with its portfolio of specialist supported housing that produces a long-term, inflation-linked income.

Even here, however, investors cannot assume such vehicles offer risk-free returns. “The biggest risk to supported living investment companies such as Civitas Social Housing and Triple Point Social Housing remains that their assets become unfit for purpose,” warns finn-Cap’s Tepes. “The risk of the government changing the terms of existing contracts – reducing rents paid – is also possibly higher than it was three months ago.”

In any case, in these more resilient sectors, investors need to be wary, with analysts now concerned about valuations. The investment trust team at stockbroker Stifel has just downgraded its rating of the entire infrastructure sector from “buy” to “hold” for exactly that reason. “While we think a significant re-rating has been justified against the background of a business shutdown and global recession, we now think that valuations are high enough,” Stifel warned in mid-June.

Equally, seemingly more risky alternative assets may provide opportunities that should not be overlooked. In the debt sector, for example, Ewan Lovett- Turner picks out TwentyFour Income as well-placed to weather the storm. “It invests in a portfolio of European asset-backed securities, which benefit from structural protection against first losses and have historically shown very low levels of defaults,” he says. “I also believe there is the potential for capital growth given the portfolio has yet to participate in the recovery seen in wider credit markets.”

BioPharma Credit, which specialises in the largely pandemic-immune life sciences sector, is another interesting possibility.

Elsewhere, Killik’s Gilligan suggests the Hipgnosis Song Fund, which has invested in writers’ and singers’ back catalogues and earns returns when listeners stream the music it owns. “We can see the long-term growth potential in streaming,” Gilligan explains. “We have some modest exposure here, though we would prefer to see a longer track record and importantly, better visibility of cash conversion, before scaling up our investment.”

Alternative assets will undoubtedly play an increasingly important role in the portfolios of many income seekers, but in such an uncertain environment, there are risks here too. Spreading your bets will be a sensible option.

Renewable energy trusts under threat?

The case for investing in renewable energy trusts looks robust. Demand for electricity will continue to increase as populations grow and industrialisation continues. And the climate change agenda means more of that demand will inevitably have to come from renewables.

Renewable energy trusts earn their returns from investments in solar, wind and other renewable energy generation assets, often benefiting from long-term supply deals with state-backed entities. They therefore look to be a slam dunk.

In March, however, investors in these trusts got a shock, with all six of the leading investment trusts hit by a dramatic sell-off that saw shares slide 30%. Those that began the year with shares trading at double-digit premiums to the value of their assets slipped to double-digit discounts.

The issue these trusts face is declining power prices. Even before the pandemic, UK power prices were falling amid fierce competition and market reforms. By the start of 2020, UK power price forecasts were down 30% compared to when these trusts were launched, and plunging demand amid Covid-19 has exacerbated the trend.

The result has been that trusts such as JLEN Environmental Assets have felt compelled to reconsider their dividend policies, removing the automatic link with inflation. But falling power prices also affect capital performance because these trusts value their assets using discounted future cash flow models built on likely future revenues. The government’s decision to cancel plans for corporation tax cuts has also hit valuations.

The cumulative effect is that these trusts no longer feel like such a sure thing. It should be pointed out that around 60% of their revenues are inflation-protected or subsidised in some other way, mitigating the effect of lower power prices. And valuations have recovered markedly since March, with most trusts in the sector now back on chunky premiums.

Still, the volatility of the last three months is a reminder of the need for caution – and the recovery means valuations are once again being questioned.

“The sun will continue to shine and wind will continue to blow, so cash flows and dividends should be relatively robust, compared to dividends for many other equity sectors, which is a key  positive,” says Iain Scouller, an investment trust analyst at Stifel. “However, the funds’ prices have risen and premium valuations have risen too.” Stifel has therefore downgraded its view of the sector to neutral in recent weeks.