Buying infrastructure funds - 'cheap is not always cheerful'

The performance of the UK’s listed infrastructure funds continues to be dismal. The average dividend yield of the renewable energy sector is 8.9%, having spiked to an all-time high of 10.6% on 7 April, according to the Association of Investment Companies (AIC). The average yield of the infrastructure sector is 6.1%, having reached a record 6.8%. Weighted average discounts to net asset value (NAV) are 24% and 17.5% respectively.

Surely these are the sort of companies that investors should be buying as the market rotates away from growth to value investing, and from the US to the rest of the world? “Analysts believe that the pessimism is overdone,” said Annabel Brodie-Smith of the AIC. “There has been some corporate activity, shares are being bought back and assets realised.” Her view has since been partially vindicated with the higher-risk, higher-reward infrastructure funds prospering. Still, the lower-risk infrastructure funds continue to languish, as do renewables.

The subsidy trap of renewables

Renewables may not be as much of a bargain as they seem. While the companies claim the economic lives of their projects are up to 40 years, “many funds will see their subsidy revenues expire in 2032-2035, and these mechanisms are typically 60% of a fund’s annual income”, points out Iain Scouller at brokers Stifel. “Once the subsidies end, the revenues will be more volatile, as a higher proportion of revenues will be subject to market prices and the funds will lose the inflation linkage provided by current support schemes.”

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The drop-off in subsidies is taken into account in asset valuations, but dividends are likely to be squeezed. These shares may prove a good investment for those who want to collect the high dividends, but the market is unlikely to favour companies with a visible sword of Damocles hanging over them. There are other risks as well. Power prices could fall. New technology could make existing projects obsolete. Costs of maintaining equipment could rise. A future government could recoup the subsidies via tax. So Scouller’s lukewarm recommendation is probably fair.

Better prospects in the infrastructure sector

Sentiment in the general infrastructure sector was given a boost in February by the all-cash bid for BBGI Global Infrastructure at a premium of 3% to NAV (and 21% to the prevailing share price). The share prices of HICL Infrastructure (LSE: HICL), International Public Partnerships (LSE: INPP), 3i Infrastructure (LSE: 3IN) and Pantheon Infrastructure (LSE: PINT) have since revived.

BBGI invested in low-risk public-private partnership (PPP) concessions of limited life. The rest of the sector has moved steadily away into demand-based assets – these are higher risk, but also offer higher returns. The share prices of INPP and HICL, still with significant PPP exposure, offer a slowly rising dividend yield of more than 7%, plus the promise of modest capital growth.

3IN and PINT offer a lower yield of roughly 4%, but target total returns of 8%-10%. PINT returned a remarkable 14% last year from a portfolio invested 44% in digital infrastructure, 29% in power and utilities and 16% in renewables and energy efficiency. However, 3IN returned a lesser 5.1% in the six months to 30 September, held back by adverse currency movements. Its portfolio is 42% in energy transition, 22% digitalisation, 22% essential infrastructure, 8% demographic change and 6% oil storage.

So while investors may be tempted by the high yields and high discounts to NAV of the renewable-energy funds, the opposite end of the spectrum looks more attractive. PINT and 3IN, which are still on discounts of over 10%, offer better long-term prospects. As so often in investment, cheap is not cheerful.

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