Page 18 - DIY Investor Magazine | Issue 34
P. 18

Steadily declining bond yields over twenty years has been a key contributor to the success of growth equity strategies but also the growth of the listed alternatives sector.
Despite the challenges posed by rising bond yields, we believe sections of the alternatives universe provide good direct
or indirect exposure to higher inflation - HICL Infrastructure (HICL) is one. Aside from high income (4.8% dividend yield) a key selling point has been the strong inflation correlation, but not direct link with inflation and its final results will be closely followed by inflation watchers. Time-lags involved in contracts will mean any direct inflation link in revenues may take time to feed through.
In a scenario where inflation was 1% higher than currently assumed in all future periods, it’s managers say HICL’s annual total (gross, before fee) returns would increase from 6.6% to 7.4%. HICL has announced it will review the appropriateness of short-term inflation assumption; it currently assumes UK RPI at 2.75% to 2030 and 2% thereafter (CPI). If inflation does become entrenched at a higher level than currently assumed, there is a clear upside for investors in terms of NAV as well
as potentially dividends. For those seeking an investment expected to benefit from rising and/or persistent inflation, HICL is a strong candidate.
The current share price premium to NAV of 9% compares
to the five-year historic average of 7.5%, suggesting that the market is anticipating an increase HICL’s inflation assumption. Renewable energy funds also have elements of direct and indirect linkage to inflation; the direct link comes from subsidies, which are typically contractually linked to inflation and can provide from around half to two-thirds of revenues.
Other revenue comes from sales of power, which managers may or may not sell forward, muting the direct link to current high wholesale energy prices for some trusts. Over the long term, many managers argue power prices are indirectly related to inflation; currently they are directly affecting inflation.
Of the Renewable Energy Infrastructure trusts, Greencoat
UK Wind (UKW) is the most exposed to wholesale power prices, with an exposure to RPI inflation through subsidies. The contractual link with inflation, and high projected dividend cover has given the board the confidence to continue to peg the dividend to inflation since launch.
Listing in 2013, UKW’s dividend target has risen by 28.7% cumulatively, compared to RPI’s rise of 26.3% over the period. Whilst the inflation link is undeniably attractive, the trust’s unhedged exposure to the energy price marked it apart from peers (many sold forward energy production, exchanging the positive impact that recent strength would have conferred, for more visibility on future revenues).
This puts UKW in an unrivalled position to benefit from continued elevated energy prices, and inflation; 2022 dividend target of 7.72p means the shares offer a prospective dividend yield of 4.9% at current prices.
Several fund managers have positionrd for high inflation for many years, including Hamish Ballie and Duncan MacInnes, of Ruffer Investment Company (RICA) which aims to grow investors’ capital over the long term whilst protecting against risks. The Ruffer approach requires managers to be flexible and adaptable and, importantly, to be set up for more than one financial or economic outcome, believing we have entered a new regime of ‘persistent and malign inflationary pressures’.
The Ruffer house view sees two likely scenarios depending on whether policymakers try to tame inflationary pressures. The first sees a ‘tightening induced slump’, where inflation stays high but governments tighten monetary and fiscal policies; most asset classes would decline in value, especially highly priced growth stocks, and they believe that RICA’s equity puts and credit protections would support the portfolio, as in Q1 2020.
The second scenario sees inflation rising, but monetary and fiscal policy remaining accommodative; bonds and bond proxies look vulnerable in this environment, but their inflation- linked bonds with the duration hedged via payer swaptions and gold exposure should in their view contribute positively. They believe value stocks and those sensitive to real GDP growth would also do well.
RICA has exposure to bad outcomes (index-linked bonds, credit protection, payer swaptions, gold exposure, and equity put options), as well as good (attractively priced GDP- and inflation-sensitive equities).
Year to date it has performed well, with NAV +5.2% over a period in which bonds and equities are both negative.
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