Investment trust investors will have seen their discounts widen over recent years, and this is largely due to the rapid increase in interest rates that began in 2022.
The Bank of England’s Monetary Policy Committee (MPC) holds its next interest rates meeting this Thursday, and most analysts are forecasting that it will cut rates. The main debate is over the size of the cut, with consensus settling around a 25 basis point (bps) cut but some analysts thinking the MPC will go further and cut rates by fifty bps.
Even if the MPC holds rates steady at this meeting, the trajectory at present is downwards. While an inflationary shock could change the picture, it’s expected that interest rates will be lower at the end of the year than they are right now – perhaps as low as 3.25%.
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Rising interest rates hit some sectors, such as property or renewable energy infrastructure, particularly hard. But now, with rates starting to fall, “many analysts believe their prospects are looking brighter and there has been a surge of M&A activity in these sectors,” says Annabel Brodie-Smith, communications director at the Association of Investment Companies (AIC).
The AIC, which represents around 300 of the UK’s investment trusts, has polled analysts and investment trust experts about the sectors that they believe could benefit from an environment of falling interest rates. Here, MoneyWeek dives into their findings to highlight the sectors and trusts that could be set to gain if interest rates fall.
Infrastructure
Infrastructure investments could benefit in a lower-rate environment. Infrastructure projects tend to be very long-term investments, and as such investment trusts make a particularly effective means of gaining exposure.
When valuing an infrastructure investment, most professional investors use a formula called net present value to calculate how much a given project is worth today. One of the key inputs in this formula is the interest rate: the higher this is, the greater the present value of a long-term project is discounted (because higher interest rates mean that safer assets like bonds offer higher returns over time).
So falling interest rates serve to increase the present value of long-term infrastructure assets by reducing the discounting effect of interest rates.
“This discount rate effect would be more meaningful for longer life, lower risk ‘core’ economic infrastructure assets such as water, energy, transport and accommodation investments,” says Ashley Thomas, analyst at Winterflood Securities.
Thomas recommends HICL Infrastructure (LON:HICL) which invests predominantly in these areas and has 65% of its portfolio invested in the UK.
Alternatively, Thomas highlights BBGI Global Infrastructure (LON:BBGI) which invests in similar sectors but with a more global outlook, as only 33% of assets are UK-based.
Markuz Jaffe, analyst at Peel Hunt, and Colette Ord, head of real estate, infrastructure and renewable funds research at Deutsche Numis, both highlight International Public Partnerships (LON:INPP).
Ord argues that the 22% discount it currently trades at doesn’t reflect its portfolio’s return potential, and points out that “the current dividend yield of 7.7% is fully covered by earnings, and even if no further investments are made, the company could pay a growing dividend for at least a further 20 years”.
“The portfolio is around 73% weighted to the UK and some of the investments benefit from government-backed cash flows, so there is a beneficial link to reductions in gilt yields, and any impact this might have on underlying asset pricing,” adds Jaffe.
Renewable energy
Energy is of course a sub-set of the broader infrastructure sector, but renewable energy investments in particular suffered when interest rates started rising in 2022, and as such could be big beneficiaries as interest rates fall.
Bluefield Solar Income Fund (LON:BSIF) is another of Winterflood’s picks highlighted by Thomas as a renewable energy infrastructure pure play. 100% of its investments are UK-based.
One of the most popular renewable energy investment trusts is Greencoat UK Wind (LON:UKW), which “offers a pure play on the UK wind sector… and has built a strong track record of cash generation”, according to Jaffe.
Jaffe highlights that UKW’s board recently committed an extra £100 million to its share buyback program to take the total to £200 million, “one of the largest in the listed infrastructure investment company universe”. He also highlights the trust’s 22% discount to its end-of-March NAV, and 8.8% yield.
For an even deeper discount and greater yield, consider Foresight Solar Fund (LON:FSFL). This is currently trading at a 30% discount to NAV and offering a 10% yield.
The trust “offers exposure to a portfolio of solar assets located across the UK, Spain and Australia, with a development pipeline of Spanish battery energy storage system (BESS) and more solar projects,” says Rachel May, research analyst at Shore Capital.
“The board has been extremely proactive in its attempts to narrow the discount having recently announced that a further 75MW of projects have been identified for disposal,” May adds, highlighting the ongoing sales process for tis Australian portfolio and the sale of a 50% stake in its Spanish holdings at a 21% premium to book value.
Property
Real estate investment trusts (REITs) are a mainstay among investment trust and property investors. Low interest rates are generally good news for the property market: they reduce mortgage rates, thereby increasing demand for property and pushing up property prices.
It is worth bearing in mind too that a distinctive feature of investment trusts is that they can borrow money to leverage their investments, a practice called “gearing”. This debt is also subject to interest rate changes, and investment trusts with variable-rate debt can stand to benefit when interest rates fall.
“A cut in the Bank of England base rate should correspond with a reduction in the sterling overnight index average rate, or SONIA, reducing debt costs for funds with unhedged floating rate debt using SONIA as a reference rate,” explains Emma Bird, head of investment trusts research at Winterflood Securities.
As such, Bird recommends Custodian Property Income REIT (LON:CREI). 18% of its debt is subject to a variable, SONIA-linked rate, so the trust “should therefore see reduced debt costs and subsequently higher earnings as SONIA falls”.
Growth assets
Companies that are positioned for long-term growth are also hit by higher interest rates, for similar reasons to companies in the sectors above: namely, their returns are likely to take a long time to come around, and as such higher rates decrease their attractiveness relative to safer investments like gilts.
Growth assets could take the form of early-stage companies, which are likely to be private. For exposure to these, Jaffe recommends HarbourVest Global Private Equity (LON:HVPE) which uses a fund-of-funds structure to offer exposure to global private companies.
HVPE’s discount increased from 15% in early 2022 to over 50% by October the same year. It is currently around 43%, but Jaffe says that the trust is taking steps to address this.
“The distribution pool, which supports buyback activity, has seen its allocation doubled from 15% to 30%, the investment structure is to be simplified via a dedicated separately managed account with HarbourVest Partners, and a continuation vote is being introduced for the 2026 AGM,” he says.
There are also nascent industries that could take many years to recuperate significant sunk costs, but for some of them, not even the sky will be the limit from there.
Ord picks out Seraphim Space Investment Trust (LON:SSIT) and its portfolio of space technology companies.
Lower interest rates could well improve sentiment around its capital-intensive portfolio of companies, but “perhaps more significant than the change in interest rates is a focus on defence spending,” she says.
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