Inflation is proving more stubborn than hoped and interest rates are continuing to climb. The Bank of England’s latest 50 basis point interest rate increase seems unlikely to be the last. The effect of this on the investment companies’ sector has been dramatic. Discounts have widened almost across the board. Among the hardest hit have been previously prized sectors such as infrastructure and renewable energy. The share prices of funds such as HICL Infrastructure (HICL ) and Greencoat UK Wind (UKW ) fell sharply on the back of the latest rate hike.

It feels as though there is a simplistic approach being taken to valuing these funds based on the comparative yields on less risky investments such as deposits and gilts. With base rates of 5% and one-year gilts yielding 5.25%, it is reasonable to ask what the right yield for a UK-focused fund should be.

Regional looks oversold

Right at the top of the yield pile of UK-focused funds is Regional Reit (RGL ), which offers investors a 14% yield – based on its 6.6p dividend for the 2022 financial year (which was fully covered by its earnings) and a share price of 47.1p.

Regional’s first-quarter update in May highlighted that its tenants were paying the rent (96.3% of rents collected on time), its properties were mostly occupied (occupancy was 83.4% as of 31 March), and its cost of debt is fixed at 3.5%.

Most encouragingly, where it has been re-letting property, it is securing decent rental uplifts over the end of December’s estimated rental values for properties.

So far, so good, but with the shares trading on a 38% discount to the 31 March net asset value (NAV), investors are clearly pricing in a disaster.

Investors are wary of offices because of the shift to home working and regional offices in particular. However, earlier this month Regional fund manager Stephen Inglis revealed that a survey of its tenants showed that 93% of employees had returned to the office when compared with pre-pandemic times, and on average were working there 4.2 days per week.

Regional’s borrowing is high, with a loan-to-value ratio of 50.5% at the end of March. It has since sold a building for £8.6m, which will help bring that down a little. The message was of ample headroom on all of its loan covenants and the plan was to bring down the ratio to about 40% over time. Nevertheless, further falls in property values will have an impact on this.

At the end of December, the equivalent yield from rental income on RGL’s office portfolio was 9% and the reversionary yield (based on what the properties are expected to be re-let for) was 10.3%. Regional was launched in 2015, so has no track record of operating in a higher interest rate environment. However, its prospectus did have a chart of regional property yields going back to the beginning of 2001.

This showed UK base rate last stood at 5% in 2008 before the financial crisis struck, when property yields were lower than their long-term averages at below 6% for prime regional property and around 8% for secondary regional property. If we go back to 2004, those figures were about 7% and just over 10%.

SOHO and GABI

The next highest-yielding (about 11%) UK-focused fund is Triple Point Social Housing (SOHO ). The arguments for and against these funds have been well rehearsed. While it is incredibly disappointing to see large investors in Civitas Social Housing (CSH ) sell out to an opportunistic bid at a 27% discount to NAV, that makes SOHO’s 60%+ discount look cheap.

On the debt side, GCP Asset Backed Income (GABI ) offers a yield just shy of 10% and trades on a 32% discount. It has had problems with fund managers leaving – both David Conlon and Joanne Fisk have left for pastures new. I would like to think that an announcement of a new manager once one has been recruited would help narrow the discount.

GCP and NESF

However, in that stable, I much prefer GCP Infrastructure Investments (GCP ), which offers a yield of 9.4% and trades on a discount of 33%. The beauty of these funds is that they can take advantage of higher rates when making new investments. In GCP’s case, the manager is aiming to capture some of that upside but leave some money on the table to improve the overall quality of the portfolio.

As an aside, it was great to see GCP’s geothermal investment at the Eden Project in Cornwall come on stream earlier this month. GCP has a good track record of backing pioneering technology and there is scope for a lot more investment in UK geothermal energy.

GCP has a high renewables exposure but the highest-yielding pure play on renewable energy is NextEnergy Solar (NESF ), which yields 8.5%. I have talked before about the hit to renewables funds from fears of higher discount rates (the discount applied to future cashflows to calculate NAV).

Undoubtedly, there is upward pressure on discount rates, but it sometimes feels as though investors forget these funds are big beneficiaries of higher inflation. NESF just hiked its dividend target by 11% for its financial year to 31 March 2024. It reckons this will be covered 1.3-1.4 times by earnings and it already has visibility over about 1-1.1 times of that from contracted cashflows.

UK equities

There are a couple of UK equity funds that yield above 7%, both of which are trading at asset value. Abrdn Equity Income (AEI ) has a traditional portfolio of high-yielding equities, which gives it something of a value tilt and also means it has high exposure to sectors like energy (BP and Shell) and banks. By contrast, Chelverton UK Dividend (SDV ) has a bias to smaller companies, and its yield is inflated by the zero dividend preference shares in its capital structure.

All of these funds now offer yields well above deposit rate or yields on short-term gilts. However, for the most part, they also offer the prospect of dividend growth too. Some may achieve NAV growth, especially if interest rates look like plateauing or falling. I wouldn’t rule out stock-specific problems but it feels like the sector’s de-rating has gone far enough.

James Carthew is head of research at QuotedData.

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