When looking at investments, the key is to assess the return opportunity and what risks threaten that assumed level of return. In a low-return environment it is particularly important to gauge what the downside risk could be and what measures are in place to help preserve value. To illustrate how this approach can be applied, let's look at three examples.
AEW UK REIT: a well-managed property group
AEW UK REIT (LSE: AEWU) aims to deliver an 8p annual dividend by means of four quarterly payments, implying a dividend yield above 8%. The results to March 2019 show that the latest annual dividend was fully covered by earnings. Investing in predominantly regional property with a bias towards shorter leases, it has adopted an approach that runs somewhat counter to the prevailing property market focus of long-lease assets.
Shorter leases can mean higher risk to income and/or capital. Yet the manager keeps an eye on residual or alternative use value. For example, if an existing tenant leaves or defaults, how likely is AEW to find another tenant or use for the asset? Taking this into consideration reduces the risk of overpaying for prime assets that with a valuation that leaves no room for error could depreciate rapidly.
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Doric Nimrod Air 3: leasing four planes to Emirates
Owning a portfolio of four A380 aircraft leased to Emirates, Doric Nimrod Air 3 (LSE: DNA3) is a finite-life vehicle that pays an annual income of 8.25p across four quarterly payments, equating to a 9.6% yield. With Airbus planning to cease production of the aircraft in 2021, Emirates is going to have to switch from a fleet business model based on aircraft replacement to one based on refurbishment and lease extension.
While some airlines have struggled to make a success of their planes and networks, Emirates has made money and impressed customers. While the earliest models within the Emirates fleet may be selectively retired, the younger units are likely to remain with the airline.
The oldest of the DNA3 aircraft was the 37th unit to join Emirates' fleet. Furthermore, as the airline is likely to need at least 100 of these planes for the foreseeable future, the risk of the aircraft having to be sold on to the secondary market in six years' time is lower than one might expect.
Sequoia: funding infrastructure
Sequoia Economic Infrastructure Fund (LSE: SEQI) provides debt for infrastructure projects. Unlike most of its peers, it concentrates on senior secured debt (the money a company must repay first if it goes under), largely floating-rate private debt. It recently increased its dividend target by 4% to 6.25p, equating to a yield of around 5.6%.
With the downside in mind, the management team has deliberately increased the amount of senior debt in the portfolio from 50% to 65% over the last 18 months. Furthermore, it believes private debt offers better risk-adjusted returns than publicly traded infrastructure debt.
As the portfolio is invested high up the capital structure (the ratio of debt to equity), it benefits from an average "equity cushion" of 35%. Therefore, the income yield is not being achieved with unreasonable levels of capital risk.
Richard Parfect, fund manager at Momentum Global Investment Management
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