The investment companies set to benefit after rates peak

Interest rate rises took a breather in September, as the Bank of England narrowly opted to keep the base rate at 5.25% for a second month on the back of a further decline in inflation in August. It was the first break in the UK’s rising rate cycle since December 2021, and the hope is that we may finally have seen the worst of painful hikes in borrowing costs.

That’s abig deal for the many investment company sectors that are particularly sensitive to interest rates, including UK smaller companies, private equity, technology, growth capital and alternative assets such as infrastructure and renewable energy.

As Matthew Read, senior analyst at QuotedData, explains, the impact can be both direct and indirect. “The effects of higher rates on equity markets are numerous, not least because now, faced with a realistic alternative, some investors have been pulling money out of equities in favour of fixed income, which now offers the best rates of return since the financial crisis. Not surprisingly, longer-duration assets and the funds invested in them have suffered the most.”

Of course, a plateau in rates is not the same as a decline, but as Stifel head of research Iain Scouller says in a recent note, markets are interested in what happens next.

“While it may be some time before we actually see interest rates falling, we would hope that the reaching of the peak may improve sentiment and encourage investors to have a look through some of the wreckage amongst funds that have de-rated sharply in both price and discount terms against a background of rising interest rates over the past year,” Scouller adds.

Different sectors are likely to feel the benefit of declining rates in different ways. Price performance for some, such as infrastructure and renewables, is negatively correlated with gilt yields and so could be enhanced as the latter fall.

Meanwhile, growth stocks (which tend to have a significant chunk of their value discounted from some point in the future) have been hit hard, affecting funds with investments in technology as well as the growth capital sector. Similarly, many private assets have struggled.

“Investors in these trusts have been concerned about the validity of their net asset values (NAVs) – think rising discount rates in response to rising interest rates,” says Read.

Private equity could see a particularly strong rally as pressure eases on the leveraged structures widely used, according to Scouller. Moreover, PE managers use the earnings multiples of comparable listed small and mid-cap companies to calculate their valuations, so recovery in the fortunes of these comparator businesses could provide a further fillip.

At the moment the sector is still trading on an average 21% discount according to Winterflood (to 29 September), having narrowed from almost 40% in recent months. However, warns Mick Gilligan, partner in fund research at Killik, these trusts can be very costly, charging up to 4% a year in some cases; he therefore prefers biotechnology and infrastructure.

Gilligan argues that biotech, like other ‘jam tomorrow’ growth-focused industries, has been hit hard by the painful tightening in credit conditions. But the industry is entering an exciting period of activity where a lot of important patents will expire: “Drug pipelines need to be replenished, and I think now is an attractive time to buy into this space,” he comments. 

One of his choices is International Biotechnology Trust, which currently trades on a 5.9% discount (against a 52-week high of 10.6%) but pays a 4.5% dividend: “This is accretive to NAV and helpful compensation for income seekers while they await a re-rating,” he comments.

Syncona, dirt-cheap on a 43% discount against the 12-month average of 17%, is an alternative. It has successfully exited several businesses that it started from scratch, and Gilligan expects more of the same in due course.

The renewables and infrastructure sectors tend to offer investors a high degree of cashflow visibility and good inflation linkage. As Read explains: “Renewables, like infrastructure, have suffered recently as attention has turned from the opportunities offered by energy transition to the potential costs, but fundamentally there is high demand for these assets and so the long-term outlook is undimmed.”

At Kepler Partners, analyst William Heathcoat Amory picks out Greencoat UK Wind as an interesting choice. The share price has been hard-hit and it now sits on a 15% discount, which he puts down to an exodus by wealth managers in favour of fixed interest investments.

At the same time, rising rates have pushed up the discount rates used to value these assets (higher discount rates make for lower net asset values). But as Heathcoat Amory points out: “Fundamentally, nothing has changed with Greencoat UK Wind. It continues to throw out a strong dividend, currently 5.9%, and is the only trust that continues to increase it in line with inflation.”

He calculates that the trust could provide attractive total returns of around 12% a year for what is “a relatively low volatility investment. Once the market’s fears on further rate rises dissipate, I think this trust could see a re-rating.”

But Stifel does not expect any “sudden knee-jerk upswing in share prices” of rate-sensitive sectors as the market engages with the prospect of falling rates. The broker anticipates a wave of corporate activity to weed out the most badly damaged trusts.

“Even with a background of falling interest rates, there will also need to be some significant ‘tidying up’ of the sector to get share prices to levels seen a couple of years ago,” warns Scouller.