A true all rounder

The UK’s Consumer Price Index (CPI) figures for June may have been lower than expected but they were still high and it is far from clear that we are going to see inflation come down again, as much as many of us would like that to happen. Indeed, the less-reported Retail Price Index (RPI) still stood at 10.7% in June.

These increases are casting light on the difference the theoretical inflation linkage an asset may have and the actual inflation linkage that is being realised.

To demonstrate this difference, we can compare demand-based infrastructure assets, which may have higher theoretical inflation linkages to availability-style infrastructure assets.

Demand-based assets are infrastructure assets whose value is predicated on the revenue they generate from usage. These assets could be a toll road, railway line or student accomodation.

As inflation rises, the operators of these assets may have the right to increase the fees they charge to end users. However, governments can intervene to prevent them from doing so. For example, over the past 12 months, authorities in Spain, Portugal, and Australia have introduced limits on how much operators can hike toll rates or capped how much they can charge motorists over a set period of time.

Another negative factor for demand-based assets is the limit to elasticity of demand. Operators can increase fees up to a point, but beyond that it’s plausible they will see a drop off in revenue as prospective customers (e.g road users or students) are no longer able or willing to pay for the service on offer. For instance, raising rents on student accommodation buildings may not be feasible due to affordability constraints.

This lies in contrast to the availability-style assets that BBGI Global Infrastructure (BBGI) solely invests in. These are assets that typically provide a social service, like schools or hospitals. Revenues are dependent on the assets being available for use, rather than their usage. For instance, as long as a school building can be used by students, BBGI receives 100% of the income from its government counterparties, irrespective of actual usage.

This was a major strength of the trust’s portfolio during the pandemic, when cash flows from its portfolio of availability-style assets remained stable with BBGI receiving 100% of revenue, while demand-based assets saw a slump in revenues. For example, despite school closures or limited usage, BBGI received 100% of the availability fees

A more pertinent strength of the assets in the BBGI portfolio today is their inflation-linkage. BBGI only invests in availability-style assets, backed by contracts with highly-rated investment grade government counterparties. The contracts it makes are fully or partially tied to a local inflation index, meaning revenues rise contractually in line with those indices.

BBGI then mirrors these contracts with its subcontractors, who manage the infrastructure they invest in and make sure it is available for use. This offsets the risk that those subcontractors will hike their own fees, and act as an effective contractual hedge on potentially rising costs. This process creates strong inflation-linkage which functions in a simple, mechanical fashion, with no approvals required.

“We have long-term contracts with the public sector,” noted BBGI Manager Duncan Ball at a Kepler Trust Intelligence event in May. “And these have automatic ratchet mechanisms, so when RPI or CPI get published, we mark up the invoice, send it to the client, and it gets paid. It’s not tied to usage, it’s not tied to elasticity of demand.”

BBGI has an inflation-linkage of 0.5x, meaning the trust’s portfolio returns increase by 0.5% for every 1% that inflation increases in excess of previously modelled assumptions. This was slightly lower than the reported levels of linkage among BBGI’s peers, who have more exposure to demand-based assets. And yet BBGI’s NAV uplifts from inflation were superior to those peers for their most recent 12-month results.

That was true even if you factor in timings and the more conservative inflationary estimates made by BBGI. In other words, it would appear that the theoretical inflation-linkage of demand-based assets has not played out strongly in reality. In contrast, BBGI’s lower inflation-linkage has proven to be more robust so far.

That was visible when the trust released its annual report for 2022 in April. BBGI confirmed that the trust would target a 6% increase to dividends in 2023 and 2024, with the dividends expected to be fully covered. Again, this increase was significantly ahead of the trust’s peers.

Aside from the trust’s contractual inflation linkage, another factor supporting that dividend growth is the trust’s exposure to higher deposit rates. The individual portfolio companies that BBGI uses to make its investments are required to hold a substantial amount of cash.

BBGI’s combined cash holdings total approximately £400m. As readers likely need no reminding, these cash holdings were not previously generating much in the way of income, as interest rates were close to zero across the regions BBGI invests in.

That is no longer the case, and BBGI is actively pursuing virtual pooling agreements to maximise the level of interest it receives on those funds. However, BBGI is conscious of concentration risk and will spread those cash holdings around different banks, all of which have A or AA ratings.

At December 2022, the weighted average rate that cash holdings could receive was around 4%, although it’s plausible that figure could move higher as interest rates globally continue to rise. Combined with the trust’s strong inflation-linkage, rising deposit rates contributed to an increase in BBGI’s NAV last year of 6.7%. Both factors more than offset the negative impact that a higher discount rate had, which shifted to 6.9%, lower than its peers in part due to BBGI’s low risk portfolio, which has around one-third of its assets in the UK.

One area that investors are understandably concerned about is the level of gearing a trust has. Again, BBGI has taken solid measures to reduce the risks rising interest rates pose. On a corporate level, the trust occasionally makes use of short-term debt via its £230m revolving credit facility. BBGI has approximately £58m drawn on that facility, which matures in 2026. So on a fund level, BBGI is not at risk of having to refinance.

BBGI’s assets are held via individual special purpose vehicles (SPVs) and these vehicles do make greater use of gearing, due to the quality of the revenue streams their investments generate. However, this borrowing is non-recourse, overwhelmingly fixed-rate and amortised over the period of ownership.

In other words, the SPVs making investments are largely shielded from rising rates due to the fixed costs of their debt. Amortising loans over the period of ownership also means individual SPVs are not exposed to refinancing risk. This is in complete contrast to many property funds today, which have long-term structural debt that leaves them in the precarious position of either having to refinance or become forced sellers of assets to meet debt obligations.

BBGI currently has a forward dividend yield of 5.7% and, and its shares, having long traded at a premium, were priced at an 7.0% discount to NAV as at 20/07/2023.

The widening of the discount is a reflection of the shift we’ve seen into government bonds among UK investors in the past 12 months. These flows and the consequent widening of BBGI’s discount have arguably created an entry point for investors looking to lock in an attractive yield and inflation protection.

BBGI’s discount rate, currently at 6.9%, represents an attractive 3.0% premium to the weighted average risk-free rate. Moreover, BBGI arguably possesses the features investors are looking for in fixed-income – stable, low-risk cash flows - but with greater upside potential. UK Gilts, for example, have no inflation-linkage, but BBGI does. They also offer little in the way of upside, whereas BBGI may see further uplifts to NAV and a tightening of its discount. There is greater risk here, but the current risk premium provides a level of compensation for that, and the trust’s inflation-linkage and highly creditworthy counterparties also serve to mitigate downside risks.

The trust arguably represents an interesting opportunity to lock in an attractive, rising dividend as a result. BBGI is structured to minimise the risk rate hikes pose and even benefits from them in the form of higher deposit rates. Strong inflation-linkage also results in the trust’s cash flows rising as inflation does. Although further volatility cannot be ruled out, what this means is that BBGI has the potential to deliver a steadily increasing dividend but also enjoys the potential for equity upside if we ultimately see a tightening of the NAV.

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