Discounts, debt and dashed hopes: why rate cuts might not lift infrastructure funds

Despite the Bank of England cutting its base rate by 100 bps, Stifel reports that UK gilt yields have risen due to increased government borrowing, negating the expected boost to infrastructure and renewables funds. Higher gilt yields keep discount rates elevated (around 8.5-9.0% for funds like HICL and INPP), pressuring asset valuations despite stable cash flows and creating a 'buyer's market' for renewable assets. While sector discounts have narrowed somewhat, Stifel cautions that returns will likely depend more on income than asset value appreciation, mirroring pre-financial crisis conditions.

Analysis

An analysis by Stifel suggests that recent Bank of England base rate cuts, which have brought the rate down by 100 basis points to 4.25% over the past year, are unlikely to significantly boost valuations in the infrastructure and renewables sector. This counterintuitive outcome stems from the rise in yields on longer-dated UK government gilts, a key benchmark for valuing long-term assets; 10-year gilt yields are currently around 4.6% to 4.8%, and 30-year gilts exceed 5%. Stifel attributes this increase in gilt yields to heightened UK government borrowing, which surged to £148 billion last year from £87 billion a year prior, thereby expanding gilt supply and exerting upward pressure on yields. Consequently, the discount rates applied by funds like HICL Infrastructure Company Limited (LSE:HICL) and International Public Partnerships Ltd (LSE:INPP), typically in the 8.5% to 9.0% range, are expected to remain elevated, thereby depressing asset valuations despite potentially stable project cash flows. A prevailing 'buyers' market' for renewable assets further compounds this valuation pressure. While average sector discounts have seen some narrowing – from 25% in April to approximately 15% for infrastructure and 28% for renewables, partially fueled by income-seeking investors reacting to falling cash savings rates – Stifel cautions against expecting a sharp revaluation solely driven by central bank policy. The current market dynamics, with high gilt yields despite lower policy rates, resemble the pre-financial crisis environment of the mid-2000s, implying that investor returns in this sector will likely be more dependent on income rather than capital appreciation.

Key Decisions for Investors

• Investors should moderate expectations for near-term capital appreciation in UK infrastructure and renewable energy funds due to persistently high gilt yields.
• Focus should be placed on the income-generating characteristics of these assets, as returns are likely to be driven more by yield than by a significant recovery in net asset values.
• Closely monitor UK government borrowing requirements and gilt yield movements, as these factors will continue to be primary drivers of discount rates and valuations in the sector.
• Recognize that the current environment may present a 'buyer's market' for renewable assets, potentially offering selective long-term income opportunities despite overall valuation headwinds.