Heads you win, tails you wind

Readers probably don’t need to be told that the past two years have seen large fund flows into bonds. We can see this phenomenon in the near five-fold increase in net inflows to funds in Morningstar’s Global Bond funds category over the past two years.

A potential knock-on effect of these fund flows has been a widening of discounts in alternative investment trusts, with the average trust in the AIC’s Infrastructure category trading at a 20.4% discount as at 25/08/2023.

What this hints at is the degree to which investors may have come to view alternatives trusts as a type of bond proxy. When interest rates were low, the attractive yields they offered acted as a substitute for the poor returns provided by fixed-income. With rate hikes making the latter more attractive again, funds have flowed out of alternatives and back into bonds.

Understandable though this may be, it misses a couple of key points that we can see playing out with Greencoat UK Wind (UKW), a trust that invests in UK wind farms and is the largest closed-ended fund within the AIC Renewable Energy Infrastructure sector today.

One factor, which may seem almost axiomatic, is that bonds have no potential for equity upside –UKW does. To think about this in simple terms, a bond like a US Treasury or UK gilt, will pay you a fixed coupon until its maturity, at which point you will also get back your principal. The value of the income and the principal may change if you have an inflation-linked bond, but that is the ‘best’ you can hope for in terms of seeing the value of those cash flows increase over time, with the only other potential for upside arising if there is a rate cut.

The dividends you receive from a renewable energy infrastructure trust such as UKW is only a proportion of the underlying cash flows that the trust generates. By design, only a proportion of UKW’s cash generation is paid as dividends to shareholders with the remainder being reinvested to generate greater total returns for you as a shareholder. In addition, UKW deliberately maintains a balanced exposure to power prices which gives it the potential for further growth through reinvestment of additional cash generation should power prices be higher than expected.  

UKW’s performance over the last decade illustrates this process neatly. Since launch in 2013 through to 30/06/2023, the trust has paid out £836m in dividends to shareholders. However, it has also reinvested £806m of surplus cash that it has generated in that time as well.

This process has created a virtuous cycle for UKW since its IPO. Reinvestment generated more cash flows, which in turn lead to a larger asset base from which to pay a higher level of dividends, and feeds into an increase in the trust’s NAV. UKW’s performance since IPO in many ways resembles what most small cap investors would look for in an ideal world; a firm that pays a high dividend but which can still generate enough cash flows to fund some of its growth.

You can see this by segmenting the trust’s returns. From IPO through to 30/06/2023, NAV total returns were 148%. However, 67% of net returns were attributable to capital growth – far exceeding the 51% compound effect of inflation, which UKW’s managers aim to remain in line with on a NAV basis. Combined with dividend payouts, the trust’s share price total returns have been superior to all their peers since launch.

To give an idea of how far UKW has come since its IPO in 2013, the excess cash available to be reinvested in growing the NAV last year was £380m, compared to the £260m it raised when it first went public. With the added caveat that energy prices were exceptionally high in 2022, this still means that UKW generated more free cash flow to reinvest last year, after paying dividends, than it raised from equity investors at launch.

And that points to the other important component that investors may be thinking about when it comes to alternatives, namely the sustainability of dividend growth.

Looking back over the decade since launch, UKW’s lowest annual level of dividend cover has been 1.3x and last year it reached a high of 3.2x. Cumulative coverage since launch has been 2x. This high level of dividend cover has been achieved at the same time as UKW has delivered on its pledge to increase annual dividends by UK RPI inflation every year since IPO.

Investors may fear the future sustainability of dividend growth, particularly given how high inflation is. The high level of dividend coverage that UKW has should provide some reassurance on this point, but the other key is the inflation linkage of its portfolio’s cash flows.

Approximately 50% of the portfolio’s revenues are derived from subsidies with explicit inflation-linkage, so when inflation increases, the cash flows from these investments increase in line with it. Energy prices are also an input to how inflation is calculated, so there is arguably a level of inherent protection here too. So when interest rates have risen to counter inflation, UKW’s NAV has been unaffected.

As we alluded to above, the other key variable to UKW’s cash flows is the wholesale energy price. But even if energy prices were to come down markedly then UKW is likely to still have robust dividend coverage. UKW published a sensitivity in its half year results showing the dividend covered for the next five years at £10/MWh.

This power price is almost 90% lower than the average price for July 2023 and is hard to envisage given the current cost of carbon (a component of the power price), even if the cost of gas is assumed to be zero. In other words, even if inflation continues to run high and the market price of energy falls dramatically, UKW’s dividend is still secure. The effect would be lower levels of reinvestment. Moreover, if the base case assumptions that the managers have made, which includes a 20% discount to power price assumptions, that would result in dividend coverage of 2.4x over the next five years.

Despite these positives, UKW’s discount to NAV has widened to -16.4% as at 25/08/2023 – a rarity for a trust which traded at a consistent premium for close to a decade after its IPO.

However, that discount may prove to be an attraction to some investors. Partly that’s because it can act as a cushion if we see further volatility. More importantly, it’s also plausible that if the managers continue to deliver sustainable NAV and dividend growth, even if we are in a tough economic environment, then that discount will start to reflect those positive returns and tighten.

Indeed, the managers recently increased the discount rate, increasing the fund’s return to 11%, up from 9% at the end of 2021. Factoring in the discount to NAV and management charges, this would imply a net annual total return of 12% for shareholders, with 6% of that from the inflation-linked dividend and the other 6% from NAV growth (which may be being discounted by investors who focus on dividend yield alone).

At the same time, a more benign level of inflation and the end of the rate hiking cycle could also prove beneficial, as investors once again look for a more attractive yield and the UKW portfolio continues to deliver a high dividend and reinvest for further NAV growth.

The result is that UKW sits at an interesting juncture. The trust’s current discount rate implies a prospective NAV total return of 10%, more than 5% ahead of the current yield on 10-year gilts. At the same time, investors enjoy the potential for upside, regardless of whether we see positive or negative economic outcomes – something that can’t be said for bond investors.

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