Infrastructure funds’ share prices bounced this week after better-than-expected US inflation data sent gilt yields into a spiral, surprising analysts by the extent to which share prices of investment trusts are being moved by gilt and bond yields.
Stifel analysts, in a research note on Wednesday, suggested there was room for further recovery, if inflation continues to stabilise and gilt yields decline further.
Most infra funds’ prices grew more or less in line with the drop in gilt yields.
Sequoia Economic Infrastructure Income Fund Limited (LSE:SEQI) was up 4.5%, HICL Infrastructure Company Limited (LSE:HICL) rose 4.6%, GCP Infrastructure Investments PLC gained 6.1% and 3i Infrastructure PLC (LSE:3IN) was 4.6% higher.
On Thursday, Sequoia was up 3.62% over five days, HICL 7.1%, GCP 8.9% and 3i Infra 8.5%, while other infrastructure-linked funds were also showing gains, with Cordiant Digital Infrastructure Ltd up 7.3%, ICG Enterprise Trust PLC 8.7%, Gresham House Energy Storage Fund PLC up 7.6% and Gore Street Energy Storage Fund PLC (LSE:GSF) jumping 17%.
“These sharp moves confirm our previous view that a number of traders, marketmakers and hedge funds are operating trading strategies between gilts and these funds,” analysts said in Wednesday’s research note.
They assumed there was “some hasty short-closing of positions in the listed funds” on Tuesday.
High interest rates and inflation often have a knock-on effect on market dynamics and this year is no exception. When interest rates rise, as they did for most of the year, and inflation remains high then the yields or returns on government bonds are also typically higher.
This dynamic led investors to sell off lower-yielding bonds and buy up new ones that offered higher yields. A glut of bonds in the market resulting from the sell-off sent the prices of the financial instruments spiralling downwards.
Conversely, news of stabilising levels of inflation has, according to analysts, caused investors to close off their short positions and move out of bonds and back into equities.
Short-selling involves borrowing shares to sell them in the hope that they can be bought back later at a lower price. To close off a short position, a trader buys back the security.
“Yesterday’s dramatic spike in share prices is a good example of this phenomenon,” said Stifel analysts in the research note on UK investment trusts on Wednesday.
“Whilst the -0.1% difference between a 3.2% CPI figure and a 3.3% market expectation was arguably little more than 'rounding', there was a consequent dramatic fall in gilt yields. Many Infra funds saw price rises in excess of +4% on the day.”
The analysts first observed the correlation between listed infrastructure funds’ share prices and the UK ten-year gilt yield in June.
“The one year correlation co-efficient between the UK ten year gilt yield and the fund discounts has actually risen to -0.89 from -0.83 in June," analysts said.
"Hence, the attraction for traders to be active in the sector and some of [Tuesday’s] move appeared to reflect short-closing.”
Contrarian investors who weren’t put off by fears that US interest rates could be higher for longer in September and October could now be sitting on tidy profits.
“Certainly for now, the market view seems to have flipped again and contrarian investors who bought into funds such as HICL and INPP, which both traded below 120p a month ago are now sitting on some attractive profits.”
Analysts spy room for further recovery, if inflation continues to stabilise and gilt yields decline further, which could be a boon for infra trusts.
On Wednesday, the UK inflation figures for October showed a sharp decline in CPI from 6.7% to 4.6%, the largest drop in the rate of inflation since April 1992.
Stifel analysts believe that if gilt yields fall further then the discounts on infra funds will not only start to look more attractive but they will be viewed to have reached a peak.
“We do think there is scope for further recovery in the months ahead assuming continued declines in inflation, gilt/bond yields and interest rate expectations," they said.
“We think if the UK gilt yield ends the year around 4.2%, there will be an expectation that discount rates used by the infrastructure funds when valuing their portfolios will have peaked.
“This should help sentiment towards the sector.”
Analysts predict that discounts on infra trusts will fall in 2024 if bond yields continue to decline.
“Whilst we do not currently expect discount rates to be reduced materially at the 31/12/23 valuation, there may be some scope for this during 2024, assuming gilt/bond yields continue in a downward direction," they said.
All in all, that window to invest in trusts trading at a discount may finally be beginning to close.
“If share prices continue to recover, the ‘window’ for bidders may close.”