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Questor: What awaits infrastructure funds as inflation and higher rates return?
Expectations of a changed economic landscape after Donald Trump takes office have affected the outlook for assets of all kinds.
Broadly, investors expect a return of inflation and higher interest rates, which would be bad for bonds but good for parts of the stock market such as banks.
Any asset that pays a fixed income is in danger if these expectations are borne out. The price of such assets is typically anchored to that of government bonds, with a higher yield (or "spread") to reflect the higher risk.
Government bond prices invariably fall when interest rates and inflation rise - because of competition from cash savings and the diminished value of future interest in real terms.
Investments that are not actually bonds but offer similar returns are also vulnerable and there has been much talk of the dangers to "bond proxy" shares.
Such shares are seen as overvalued as a result of the search for yield, which arguably defined the stock market era that "Trump reflation" is now supposed to replace.
Another type of asset that pays a reliable income, and has therefore been a popular choice among income seekers in the low interest rate environment, is infrastructure investment trusts.
These listed funds, which are relatively new to the stock market, invest in a variety of assets, including public sector buildings, wind and solar farms and toll roads. Such assets tend to have a predictable life and to pay predictable incomes, making the funds appealing to risk-averse investors who need income.
If, however, all yield plays are in danger in a world of rising rates and inflation, are infrastructure funds really low-risk?
Questor believes that there are three sides to this question.
The first relates to the income that the trusts' assets generate. To be truly bond-like, the assets would have to generate a fixed income, but in many cases the income produced by the assets is linked to inflation or to power prices. This gives the trusts a degree of protection in a world of rising rates - just how much depends on the exact mix of assets and the terms under which they operate.
The second point concerns the valuation of the trusts' assets. Investments such as hospitals and wind farms are not themselves quoted, so there needs to be another way to value them. The trusts tend to do so in relation to the expected cash flows, which they discount to a present-day value.
The discounted cash flow method of valuation can sound complicated but is nothing more than saying that we would all rather be given £100 today than £100 in a year's time and then putting a figure on the difference in value between the two.
The rate at which future cash flows are discounted tends to reflect broader interest rates and inflation, so if these rise, we can expect higher discount rates. If the value of £100 in a year's time is discounted more, it means an asset's future cash flows are worth less today and therefore the asset itself is worth less.
At first sight this would appear to be bad news for infrastructure funds.
But there is a cushion in that they have not used the fall in interest rates that we have seen in recent years to cut their own discount rates, so there is less need to increase them if inflation does return.
Additionally, if the future cash flows increase because of the inflationlinking discussed above, so too do the asset values for a given discount rate.
The third consideration is the premium at which infrastructure trusts trade. 3iInfrastructure (3IN), for example, trades at a premium of 18.4pc and yields a relatively modest 3.8pc, while John Laing Environmental Assets (JLEN) has a more modest 5.5pc premium and yields 6pc.
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The similar sounding John Laing Infrastructure Fund (JLIF) trades at an 8.1pc premium and yields 5.4pc. HICL Infrastructure Company (HICL), another popular choice, has a premium of 11.7pc and a yield of 4.7pc.
Questor feels nervous about high premiums on funds whose assets are likely to appreciate only slowly, if at all.
While the arguments about income and discount rates set out above may provide rational support, market sentiment can change quickly and we could well envisage large premiums disappearing - which means share prices falling.
We therefore see the sector as no more than a hold for income seekers, with the best bets being John Laing Environmental Assets and Greencoat UK Wind (UKW), which has a 9.8pc premium and a yield of 5.3pc.
Questor says: Hold
Ticker: Greencoat UK Wind (UKW)
Questor archive: telegraph.co.uk/questor
Contact us: questor@telegraph.co.uk