Lower interest rate investment trusts

Interest rate increases in 2022 hurt a lot of investment trusts, which are long-term investment vehicles

Is now the right time to invest in one of these abandoned industries, given that interest rates are predicted to decline by the end of the year?

The recent widening of investment trust investors' discounts can be attributed in large part to the sharp rise in interest rates that started in 2022.

This Thursday is the next interest rate meeting of the Bank of England's Monetary Policy Committee (MPC), and most analysts predict that rates will be lowered. The main point of contention is the magnitude of the cut; most analysts agree on a 25 basis point (bps) cut, but some believe the MPC will go even lower and lower rates by 50 bps.

The current trend is downward, even if the MPC keeps rates unchanged at this meeting. It is anticipated that interest rates will be lower at the end of the year than they are now, possibly as low as 3 to 25 percent, though an inflationary shock could alter the reality.

Certain industries were particularly hard hit by rising interest rates, such as real estate or infrastructure for renewable energy. But now that interest rates are beginning to decline, "many analysts believe their prospects are looking brighter and there has been a surge of MandA activity in these sectors," according to Annabel Brodie-Smith, the Association of Investment Companies' (AIC) director of communications.

About 300 investment trusts in the UK are represented by the AIC, which has surveyed analysts and experts in investment trusts regarding the industries they think would profit from a climate of declining interest rates. Here, BFIA delves into their research to show which industries and trusts stand to benefit from a decline in interest rates.

Facilities.

In a lower-rate environment, investments in infrastructure could yield benefits. Investment trusts are a particularly good way to increase exposure because infrastructure projects are typically very long-term investments.

The majority of seasoned investors use a formula known as net present value to determine the current value of an infrastructure investment. The interest rate is one of the formula's main inputs; the higher it is, the more the present value of a long-term project is discounted (since higher interest rates indicate that safer assets, like bonds, offer higher returns over time).

Therefore, by lessening the discounting effect of interest rates, declining interest rates help to raise the present value of long-term infrastructure assets.

According to Ashley Thomas, an analyst at Winterflood Securities, "this discount rate effect would be more meaningful for longer life, lower risk core economic infrastructure assets like water, energy, transportation, and accommodation investments."

Thomas advises HICL Infrastructure (LON:HICL), which has 65% of its portfolio invested in the UK and primarily makes investments in these sectors.

As an alternative, Thomas points to BBGI Global Infrastructure (LON:BBGI), which has a more global perspective despite investing in comparable industries, as only 33% of its assets are located in the UK.

International Public Partnerships are highlighted by Markuz Jaffe, an analyst at Peel Hunt, and Colette Ord, head of research for real estate, infrastructure, and renewable funds at Deutsche Numis (LON:INPP).

"The current dividend yield of 7.7 percent 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," Ord argues, arguing that the 22 percent discount it currently trades at does not reflect the return potential of its portfolio.

Jaffe continues, "There is a positive correlation between reductions in gilt yields and any effect this might have on underlying asset pricing, as the portfolio is approximately 73% weighted to the UK and some of the investments benefit from government-backed cash flows."

Sustainable energy.

Although the energy sector is obviously a subset of the larger infrastructure sector, investments in renewable energy in particular suffered when interest rates began to rise in 2022 and could therefore benefit greatly from a decline in interest rates.

Another one of Winterflood's selections that Thomas emphasized as a pure play for renewable energy infrastructure is the Bluefield Solar Income Fund (LON:BSIF). Its investments are all based in the United Kingdom.

Greencoat UK Wind (LON:UKW) is a well-known renewable energy investment trust that "offers a pure play on the UK wind sector and has built a strong track record of cash generation," according to Jaffe.

In order to make the total 200 million, Jaffe points out that the board of UKW recently committed an additional 100 million to its share buyback program, making it "one of the largest in the listed infrastructure investment company universe." The trust's 8-point 8 percent yield and 22 percent discount to its end-of-March NAV are also highlighted by him.

Take a look at the Foresight Solar Fund (LON:FSFL) for a higher yield and greater discount. This is currently offering a 10% yield and trading at a 30% discount to NAV.

This 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," according to Rachel May, Shore Capital's research analyst.

May continues, pointing out the ongoing sales process for its Australian portfolio and the sale of a 50% stake in its Spanish holdings at a 21 percent premium to book value. "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," she says.

Property.

A staple among property and investment trust investors are real estate investment trusts, or REITs. In general, low interest rates are beneficial to the real estate market because they lower mortgage rates, which raises demand for real estate and drives up prices.

It's also important to keep in mind that one of the unique characteristics of investment trusts is their ability to borrow funds in order to leverage their investmentsa process known as "gearing." Investment trusts that have variable-rate debt may profit when interest rates decline because this debt is also susceptible to changes in interest rates.

"A reduction in the sterling overnight index average rate, or SONIA, should be in line with a cut in the Bank of England base rate. This would lower the cost of debt for funds that have unhedged floating rate debt using SONIA as a reference rate," says Emma Bird, head of investment trusts research at Winterflood Securities.

Custodian Property Income REIT (LON:CREI) is therefore suggested by Bird. The trust "should therefore see reduced debt costs and subsequently higher earnings as SONIA falls" because 18 percent of its debt is subject to a variable, SONIA-linked rate.

Growth resources.

Higher interest rates also hurt businesses that are positioned for long-term growth, for the same reasons as businesses in the aforementioned sectors: higher rates make them less appealing in comparison to safer investments like gilts because their returns are probably going to take a while to materialize.

Early-stage businesses, which are probably private, could be considered growth assets. Jaffe suggests HarbourVest Global Private Equity (LON:HVPE) for exposure to these, as it offers exposure to international private companies through a fund-of-funds structure.

Early in 2022, the HVPEs discount was only 15%; by October of the same year, it had grown to over 50%. As of right now, it stands at about 43 percent, but Jaffe says the trust is working to change that.

"A continuation vote is being introduced for the 2026 AGM, the investment structure is to be simplified via a dedicated separately managed account with HarbourVest Partners, and the distribution pool, which assists with buyback activity, has seen its allocation doubled from 15 percent to 30 percent," he says.

Even though it might take several years for some emerging industries to recoup large sunk costs, for others, the possibilities are virtually endless.

Ord chooses Seraphim Space Investment Trust (LON:SSIT) and the space technology businesses in its portfolio.

Despite the fact that "perhaps more significant than the change in interest rates is a focus on defence spending," she says, lower interest rates could boost sentiment regarding its capital-intensive portfolio of companies.