What's happening to infrastructure funds?

This is because the income generated from infrastructure assets is typically paid by the government, or a quasi-government agency, providing a similar level of security to bonds.

Examples could include renewable energy assets, hospital buildings or roads – the latter often built under private finance initiatives.

But often the income is inflation-linked, which provides a cash flow that may be durable during tough economic times.

Yet over the past six months, the AIC Infrastructure sector has lost 11 per cent. 

James Sullivan, head of partnerships at Tyndall Investment Management, says one of the issues faced by these funds is that, as bond yields have risen, the income available from infrastructure becomes relatively less attractive.

Generally speaking, income-bearing assets are priced relative to bond yields, but also at a premium to this, known as the risk premium. The size risk premium varies across different asset classes, and may be quite low for an asset such as infrastructure, but if bond yields are rising, then the total yield required to make other asset classes attractive must also rise.

This calculation is then extrapolated over multiple years to create what is known as the discount rate, that is, an attempt to place a value today on an asset based on the future cash flows generated by that asset.

Source: AIC (total assets, stated month end)

Mick Gilligan, a partner at wealth management firm Killik and Co, says: “Think of the discount rate as the level of ‘compensation’ that you would need for taking on the risk of the investment. Lots of risk equals high discount rate. Very little risk equals low discount rate.  

"A receipt of £100 in a year’s time discounted at 10 per cent is worth £90.91 today (100/1.1=90.91). If the cash flows are very predictable the discount rate should be lower. So, £100 in a year’s time discounted at 5 per cent is worth £95.24 today (100/1.05=95.24).

This discount rate will almost certainly rise by the time of the next company disclosure... But markets don’t wait. They adjust prices now.Mick Gilligan, Killik and Co

"There are two components to the discount rate. There is the risk-free component – the risk-free rate, typically government bond yields that provides compensation for waiting (that is, the time value of money). And there is the risk premium component – the element that reflects the risk of default or delay on the underlying cash flows.”

Sullivan points out that as bond yields rise, this causes the long-term value of the cash flows generated from an infrastructure asset to decline, meaning the capital value of the physical assets owned by infrastructure funds has fallen, and this will be reflected in the valuations of the funds. 

Because physical assets are not priced on a daily basis, in the way that listed equities and bonds are, it may take some months for infrastructure funds to mark down the value of the assets they own, and that would reduce the net asset value of infrastructure investment funds.

Sullivan says the sell-off in infrastructure funds in recent months is, at least in part, a function of investors anticipating the future write down in the value of the assets held in those funds. 

Gilligan says: “The average discount rate for the HICL Infrastructure portfolio, for example, was 6.8 per cent in the company’s last set of results in June.

"Another way of looking at this is that if everything goes according to plan (that is, based on management assumptions about the income it receives, economic conditions, etc) the portfolio will grow by 6.8 per cent over the next year.

"This discount rate will almost certainly rise by the time of the next company disclosure at the full year results in December, unless we see bond yields reverse dramatically. But markets don’t wait. They adjust prices now.” 

Nominal yields have now reached a level where the risk premium 'buffer' for some funds is effectively gone.Matthew Hose, Jefferies

Matthew Hose, an equity analyst at Jefferies, says: “While in the past movements in long-term government bond yields have not directly influenced portfolio valuations, nominal yields have now reached a level where the risk premium 'buffer' for some funds is effectively gone, meaning further yield movements have the potential to translate into discount rate increases.

"The caveats here are that discount rates are also dependent on transactions (which should eventually reflect the yield environment), and that funds' inflation-linkage, and to a lesser extent any deposit rate sensitivity, act as potential offsets.”

Thor Johnsen, fund manager of the Digital 9 Infrastructure fund, acknowledges that the risk-free rate has risen in recent months, with this having an impact on the share prices of infrastructure funds.

But he says: “The point is these assets are very long term, the revenues are long term as well. We own digital infrastructure assets, those are things that are a structural growth story. Of course all assets in this space are impacted by risk-free rates and discount rates, but those are short-term factors.”  

There is an element of subjectivity to all discount rates, with some fund providers choosing a more aggressive number than others, reflecting the different levels of risk associated with different types of infrastructure. 

The point is these assets are very long term, the revenues are long term as well.Thor Johnsen, Digital 9 Infrastructure fund

Gilligan says his preference right now is for infrastructure funds that invest in social housing and other assets of that kind, rather than renewable energy assets, as there is “less certainty” around the reliability of the cash flows of the latter. 

Sullivan expects the value of some of the assets held in infrastructure funds to be written down this year. 

Hose says another consideration is that many infrastructure investment funds have taken on short-term debt in recent years in order to finance their operations.

He says when these trusts have to refinance their debt, they will have to pay higher interest rates than has been the case in the recent past, which would have a negative impact on the returns investors can expect in future. 

Hose says this could lead to funds selling assets in the coming months as they seek to raise capital to pay down debts.

Investor demand continues to be strong for infrastructure open-ended funds, with the latest data from the Investment Association showing inflows of just over £200mn in September.

Whether that trend can continue as assets get written down in the months to come is something advisers and their clients will be watching keenly.

David Thorpe is special projects editor at FTAdviser