With BT the latest household name to suspend dividends and interest rates at record lows, income investors face an arid environment. Investment companies in alternative sectors can offer something different, including streams of income with low correlations to the wider stock market. What are the opportunities and risks of investing in alternatives and what can they offer to an income portfolio hit by COVID-19?
The Association of Investment Companies (AIC) has spoken to investment company analysts to find out which alternative investment companies they prefer for income-seeking investors.
Annabel Brodie-Smith, Communications Director of the Association of Investment Companies (AIC), said: “Despite a number of countries beginning to emerge from lockdown, the environment for many businesses remains extremely challenging, putting pressure on company dividends. Investment companies investing in alternative assets such as infrastructure or social housing could be worth considering for income-seeking investors. Infrastructure investment companies provide exposure to a wide range of income-generating assets, from solar parks and wind farms to bridges and water pipelines.
“Investment companies are an ideal way to invest in these assets, which are hard to buy and sell. Their closed-ended structure means managers can focus purely on performance and there is no risk of fire sales and suspensions. Investing in alternative assets does come with different risks to investing in mainstream equities, so it's important that investors do their research and speak to a financial adviser if they are in any doubt.”
Infrastructure and social housing
Alan Brierley, Director of Investment Companies Research at Investec, said: “Sustainability of income is key and our preferred sector is Infrastructure. Our recommendations include HICL Infrastructure, The Renewables Infrastructure Group, Greencoat UK Wind and Sequoia Economic Infrastructure Income. These companies give a diversified exposure to social, economic and renewable infrastructure along with infrastructure debt. Within the debt sub-sector, many constituents had over-promised and under-delivered even in a benign credit environment before the onset of the pandemic. Here, stock selection is even more critical – our preferred investments are GCP Asset Backed Income, which invests in asset-backed loans, and BioPharma Credit which provides debt capital to the life science industry.”
Monica Tepes, Head of Investment Companies Research at finnCap, said: “If you are looking for as much certainty as possible that your dividends are not going to be cut, I think you need to look at sectors where either the local or state government is your counterparty, or your payments come from businesses which are unaffected or even benefit from the current environment. In the first category I can only put infrastructure equity (BBGI, International Public Partnerships, HICL Infrastructure), infrastructure debt (GCP Infrastructure Investments, Sequoia Economic Infrastructure Income) and supported living (Civitas Social Housing, Triple Point Social Housing REIT). In the second category I think there are no clear winning sectors – certain players in the logistics sectors seem to be in the right assets, but others aren’t. If the products transiting through your logistics centres are not selling, you will have trouble collecting rents.”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “I believe investment companies investing across a range of alternative asset classes remain attractive to income investors. In particular, core Infrastructure funds look to be trading on attractive yields given their long-term, government backed income streams and with a high degree of inflation linkage. I believe an attractive option is International Public Partnerships. It invests in a diversified portfolio of assets providing essential services and recently reiterated its 2020 dividend target, putting it on a 4.8% yield. HICL Infrastructure offers a 5.0% yield and whilst it has more exposure to demand-based assets, we understand these are robustly structured to withstand near-term reductions in revenues.
“I believe that certain specialist debt investment companies offer an attractive yield, even in the face of an expected increase in defaults. For example, we rate the management team of TwentyFour Income highly and think it offers an attractive yield of 7.1%. It invests in a portfolio of European asset-backed securities, which benefit from structural protection against first losses and have historically shown very low levels of defaults. I also believe there is the potential for capital growth given the portfolio has yet to participate in the recovery seen in wider credit markets and the portfolio yield was 12.5% at 31 March.”
Social housing – rent collection “unaffected by the COVID-19 crisis”
Conor Finn, Investment Fund Analyst at Liberum, said: “Aside from Infrastructure and Renewable Energy Infrastructure funds, we believe the social housing REITs offer the prospect of long-term, uninterrupted income. Following recent acquisitions, Civitas Social Housing has achieved full dividend cover on a forward-looking basis and we expect an increase to cover of 1.08 years by Q1 2022. The portfolio produces a long-term, inflation-linked income stream from specialist supported housing. Civitas is focused on accommodation for individuals with care needs that are moderate to high. Rental payments from housing associations are funded from housing benefit. Rent collection in the sector has been unaffected by the COVID-19 crisis, unlike other real estat
Diversification – income generated “from a range of asset classes”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “The investment companies I have highlighted generate their income from a range of asset classes with different underlying return drivers. In addition, they have diversified portfolios with a large number of underlying investments. For example, International Public Partnerships has over 100 projects in the UK, Europe, North American and Australia, including public private partnership projects such as schools, courts and police stations as well as offshore transmission cables, transport assets and the Thames Tideway Tunnel project. TwentyFour Income offers exposure to both mortgage and corporate loans across Europe, backed by thousands of underlying loans.”
Conor Finn, Investment Fund Analyst at Liberum, said: “The income stream from Civitas Social Housing should be uncorrelated with the wider market. The diversification benefits have been borne out by the share price performance of Civitas this year: +7.7% year-to-date vs -22.3% for the All-Share. The weighted average lease term on the portfolio is 24 years and the tenants require long-term accommodation, for example the average age of the tenants in the portfolio is 33. There is an acute shortage of supported housing in the UK and demand is projected to rise as a result of an expanding and ageing population, medical improvements and healthcare policy.”
Risks – “increased staffing costs and PPE”
Monica Tepes, Head of Investment Companies Research at finnCap, said: “I think the biggest risk to Infrastructure is that the government breaks or renegotiates the contracts or nationalises the assets. It’s unlikely, but possibly less so than three months ago. The more likely risk, I think, is that the operators of the assets encounter financial difficulties and the cost to the fund to run the assets increases, squeezing net cash flows.
“I think the biggest risk to supported living investment companies like Civitas Social Housing and Triple Point Social Housing REIT remains that their assets become unfit for purpose – so they can no longer operate as supported living accommodation and receive the higher rent. The risk of the government changing the terms of existing contracts – reducing rents paid – is also possibly higher than it was three months ago, but I think unlikely. More likely, I think, is that there will be great pressure on rents when negotiating new leases. I think the providers of care are likely to face increased financial pressures, such as increased staffing costs and PPE.”
Conor Finn, Investment Fund Analyst at Liberum, said: “The regulator has been critical of the social housing sector and has highlighted issues at a number of housing associations. The counterparties to the leases are typically smaller housing associations. Civitas Social Housing has been working with the housing associations to address the issues raised. Civitas has led several initiatives to improve professionalism and the long-term sustainability of the sector. These include force majeure clauses in the leases, assisting housing associations with governance changes and board appointments and supporting the establishment of a not-for-profit, community interest company. On a portfolio level, Civitas has also been working on increasing the amount of the portfolio that is supported by 25-year, back-to-back care provider leases which represent 30% of the portfolio.”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “The risks vary widely according to the nature of the underlying assets. International Public Partnerships has modest exposure to regulated assets, some of which are subject to periodic price controls where the regulator sets the allowed return. A small part of the portfolio has some demand risk, although there are various downside mitigations within certain contracts which provide some comfort. However, the majority of revenues have a high level of predictability under availability-based payment structures, or through senior debt investments. TwentyFour Income could be exposed if default levels in European loans or mortgages are significantly higher than expectations, although there is typically first-loss protection and current valuations are pricing in an increase in defaults.”
Outlook – “income-producing alternative assets even more attractive”
Conor Finn, Investment Fund Analyst at Liberum, said: “The range of alternative income investment companies has increased substantially in recent years. 2020 will be a pause for breath in terms of growth for the sector but the outlook remains positive. Several of the listed funds have only operated under benign conditions and steady performance during this period will provide confidence in management teams and asset classes to produce long-term returns. The structure helps as it allows managers to invest in assets that can produce long-term income but may not necessarily suit an open-ended structure.”
Ewan Lovett-Turner, Director of Investment Companies Research at Numis Securities, said: “The landscape has changed in recent months and many assets that were thought to have dependable income streams have seen dividend cuts. Numerous property, asset leasing and specialist debt investment companies have suspended or reduced dividends, reflecting actual or expected reductions in cash flows. I believe that there remains the threat of further dividend cuts in these sectors and it is unclear when and at what level dividends will be restored.
“Some investment companies have the ability to make distributions from capital and pay uncovered dividends, and this may provide protection for the level of dividends for some funds. However, investment companies investing in less liquid assets typically have a closer link between cash flows and dividend payouts, meaning they may have less flexibility to use reserves compared to equity investment companies. As a result, we believe investment companies that can demonstrate a security of income in these uncertain times will be highly valued by investors and attract a premium rating.”
Monica Tepes, Head of Investment Companies Research at finnCap, said: “The scarcity of income is nothing new and the economic backdrop of ultra-loose monetary policy is going to make income-producing alternative assets even more attractive. The investment company alternative income sector has grown tremendously over the last 15 years precisely because it can fill this gap, which open-ended funds, equities and bonds can’t. I think there will be more income solutions to come from this space.”
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