If you were hoping falling interest rates would breathe life into the battered infrastructure and renewables sector, Stifel has some sobering news.
Despite the Bank of England trimming its base rate by 100 basis points over the past year to 4.25%, the yields on longer-dated UK government bonds, or gilts, have actually risen.
That matters because these gilt yields are a key ingredient in how infrastructure and renewables investment funds value their assets.
When investors assess the value of long-term cash-generating projects, such as toll roads or wind farms, they use a discount rate to work out what those future earnings are worth today.
Starting with gilts
This rate often starts with the yield on gilts, the UK’s "risk-free" debt, with a premium added for risk.
But while Bank Rate has dropped, the yield on 10-year gilts has climbed to around 4.6% to 4.8%, and 30-year gilts are over 5%.
Why? According to Stifel, it’s mainly because government borrowing keeps rising.
The UK borrowed £148 billion last year, up from £87 billion just a year earlier. The budget shortfall continues to widen, pushing up the supply of gilts and putting upward pressure on yields.
That means the discount rates used by funds such as HICL Infrastructure Company Limited (LSE:HICL) and International Public Partnerships Ltd (LSE:INPP), typically around 8.5% to 9.0%, are likely to stay high.
High discount rates
And high discount rates mean lower asset valuations, even if the projects themselves are delivering stable cash flows. There’s also a broader "buyers' market" for renewable assets, as some investors sell down positions, which puts further pressure on valuations.
Funds have already re-rated somewhat this year: average sector discounts have narrowed from 25% in April to about 15% for infrastructure and 28% for renewables.
That’s helped by demand from income-seeking investors as cash savings rates fall. But Stifel cautions against expecting a sharp revaluation on the back of interest rate cuts alone.
Pre-crash
The environment today resembles the pre-financial crisis world of the mid-2000s, when gilt yields were similarly high and many of these listed funds were launched.
Even though discount rates incorporate a buffer, essentially an extra spread over gilts, this margin is already wider than it was in 2007, reflecting changes in portfolio risk.
The message? Discount rates might not budge much, even as the Bank Rate does. For investors in the sector, that means returns will likely rely more on income than on a bounce in asset values.