The other day, I was at an investment conference.
It’s a hazard of the job. A lot of the time they’re pretty dull and predictable.
Everyone talks up their own asset class. Bond managers push bonds. Commodity fund managers push commodities. And for equity fund managers, stocks are always cheap, regardless of what the ratios suggest.
Since they can’t all be right, the net result is just noise.
But I got a pleasant surprise at this particular conference – one bond fund manager stood up and said outright that yields were too low, and he was keeping as much of his money in short-term bonds as possible.
That’s a bit like an equity manager saying he’s stuck all his money in cash because the stock market is too expensive.
But if bonds are too expensive, how can you get a bit of income without taking on all the risk of investing in equities?
Bond yields have collapsed
Two years ago everyone was rushing to ditch European fixed income. With the euro looking set to unravel and investors forced to take ‘haircuts’ on Greek debt, bond yields soared to record levels.
However, the pledge by the head of the European Central Bank (ECB), Mario Draghi, in July 2012 to do “whatever it takes” to keep the euro together, seems to have convinced markets that future defaults are out of the question.
So far the ECB has, in fact, done nothing to follow up its threat. We also had the crisis in Cyprus – which saw large depositors having to take ‘haircuts’. Yet rates on all types of European debt plunged.
In the summer of 2012, ten-year Spanish and Italian bonds yielded around 6% and 7.5% respectively. They now trade at around 2.5%.
Ireland completely stopped issuing new long-term debt between 2010 and 2012, while it underwent a brutal austerity programme. At one point yields on its ten-year bonds went as high as 14%. However, ten-year yields are now also 2.5%.
This means that a small country with a debt-to-GDP ratio of more than 120% pays the same amount to borrow money as the US – still the world’s largest economy – does.
Wow. You don’t half to be a ‘glass half-empty’ type to see that as a little bit over-exuberant.
There even seems to be an appetite for Greek debt. A recent five-year bond issue was oversubscribed by eight times – in other words, investors were queuing up for it. It currently yields less than 5% a year – ridiculously low for a country that could still end up leaving the euro. (For more on all this, check out our roundtable discussion in the next issue of MoneyWeek magazine, out on Friday – you can get your first four issues free here.)
Making money from building new schools and hospitals
So what’s the alternative if you’re looking for a decent income? One asset worth considering is ‘social infrastructure’ funds. These are listed companies that provide the buildings needed for public services. In other words, schools, hospitals, prisons and the like.
At first glance this might seem highly risky. There’s a lot of political debate about the role that private companies should play in the public sector. Like many people, I’m worried about the long-term impact of outsourcing in the NHS. So the threat of political turbulence seems high.
But things are more straightforward than they seem. The key thing to remember is that these firms do not run the actual services. They have no involvement with teachers, doctors, patients or children.
Their role is simply to build the physical buildings, and then maintain them. In return they get an annual fee for a fixed period. When this runs out, they hand over the asset to the government, so it doesn’t matter what happens to underlying property prices.
Because of the long-term nature of the investment, the contracts are also written to take much of the risk away. The annual fee is fixed at the start, and adjusted for inflation. So that protects against rising prices.
It also means that these companies get paid whether the building is being used or not – so there’s no comparable risk to the ‘void’ periods suffered by landlords, for example. While this latter provision may seem overly generous (at least from a taxpayer’s point of view), it protects these firms from the government changing its mind after the money has been spent.
Subcontracting the maintenance to third parties, and taking out buildings insurance can further cut risk. Spreading investments over several projects – plain old diversifications – ensures a steadier flow of cash.
As a result, the main risk is the counterparty risk – the chance that the British government will go bust. You may have your own take on how likely that is. But put simply, it means that assuming the contracts remain in force, these funds should only be slightly more risky than gilts.
Of course, you may still think that deals – private finance initiatives (PFI) – are poor value for money for the taxpayer. After all, if they are so profitable, then surely the government could save taxpayers’ money by building the assets itself. The reality – a cynic might say – is that PFI is just a clever way for heavily-indebted governments to hide the true costs of projects off their balance sheets.
These are both legitimate criticisms. And it does mean that on top of the counterparty risk, political risk remains a real issue. But the reality is that there is a cross-party consensus on the need to renew and expand our infrastructure. And all parties also believe that this sort of investment is the easiest way to spur growth.
At the same time, we have record levels of debt. That means direct state spending is off the table. So off-balance sheet tricks are exactly what a government – of any stripe – needs. The bottom line is that there are likely to be more public-private building and maintenance partnerships in the future.
What we think you should buy
The one downside is that these funds typically trade at a premium to their net asset value. Managers’ fees and expenses also act as a drag on returns. However, each of the major trusts has a dividend of around 5%. To me, that compares very favourably in risk/reward terms to the 2.5% you could get from buying an Irish government bond, for example.
It’s true that this is an apples to oranges comparison – an Irish government bond has a maturity date at which you get repaid your capital, and these trusts don’t.
But in the past, there have been times when the yield gap between infrastructure investments and gilts, for example, has been far narrower than it is today. So as a rough and ready measure, it suggests to me that these trusts are decent value just now.
One of the most attractive-looking is the HICL Infrastructure Investment Trust (LSE: HICL). It has long record and is involved in a large number of projects. The total expense ratio is also reasonable at 1.13%. My colleague David Stevenson recently wrote about several similar funds.
By the way, if you are interested in getting an income, and you’re happy with the idea of investing in big blue chip stocks, you should check out my colleague Stephen Bland’s Dividend Letter. Stephen’s whole philosophy is focused purely on income, and it’s a strategy that has delivered well in the past. Find out more about it here.
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