Income investors discouraged by the fall in high-yielding social infrastructure funds following Labour’s vow to scrap private finance initiatives (PFIs) in the NHS, don’t have to look far for alternative sources of reliable dividends.
Within the AIC Specialist: Infrastructure sector housing the previously popular investment companies investing in contracts to run roads, schools and hospitals - such as HICL (HICL), BBGI (BBGI), John Laing (JLIF) and International Public Partnerships (INPP) - are two less well-known funds taking a different tack to the same area.
Instead of investing in the equity - or shares - of infrastructure projects and earning dividends on their stakes, GCP Infrastructure Investments (GCP) and Sequoia Economic Infrastructure Income Fund (SEQI) lend to infrastructure projects. They both earn interest on their loans and bonds which they pass on to their shareholders in quarterly dividends. At their current share prices these support highly attractive yields of around 6%, which is about the same level as the social infrastructure funds.
Not only do both have far smaller exposure to UK PFI contracts (in SEQI’s case just 2%) - a feature that has shielded them somewhat from the recent fall-out in the sector - but the way they operate arguably makes them safer investments. As lenders of loans secured on infrastructure assets, both GCP and Sequoia stand at the front of the line of creditors, ahead of equity investors, should anything go wrong.
With their share prices still trading at premiums above their net asset values (NAV) GCP and Sequoia can still raise money through new share issues, unlike HICL, JLIN and INPP whose shares languish on discounts below NAV .
GCP, which lends to UK social housing and renewable energy providers, raised £100 million in a share placing to professional investors in January, £40 million more than the £1 billion Jersey-based fund had sought.
Last week, Sequoia, an £800 million global fund lending to a wide range of infrastructure projects in the developed world, said that it had deployed the £160 million it raised from shareholders last May. It said it was considering a further ’tap’ issue of up to 10% of its share capital in order to repay some debt and provide funds for new investment.
There were no further details of the fund raising, which again will only target professional ‘qualified’ investors. However, it did say the new shares would be issued at a small premium to NAV to cover costs, most likely next month. The shares closed last week at 104.5p at a 3% premium to their 101.46p NAV.
Steve Cook, SEQI’s portfolio manager, said retail investors were ‘very important’ to the company following its promotion to the FTSE 250 last August. He indicated a future larger fund raise like last May’s placing and subscription offer would include an intermediaries offer to the stock brokers and online platforms used by DIY investors.
So what do investors need to know about the three-year old, Guernsey-based investment company whose shares they can buy now or wait to buy them free of 0.5% stamp duty in a future share issue?
Sequoia Investment Management, SEQI’s fund manager, is an infrastructure debt specialist that Cook and three other former Morgan Stanley bankers founded after the 2008 financial crisis when banks were forced to scale back lending.
Named after the giant and ancient sequoia, or redwood, trees whose seedlings only flourish after forest fires - or in this case credit crunches - the firm is currently steering the London-listed fund into a more defensive direction aimed at preserving capital and locking in secure interest rates.
SEQI aims to generate a total annual return of 8% which after costs and a 6p dividend should leave a little to grow the NAV. Its annual ongoing charges were 1.26% in its last financial year, according to the Association of Investment Companies (AIC).
With the cost of borrowing rising in the US and UK, these are turbulent times for bond investors though. Sequoia has increased the amount of floating rate notes, or bonds, to 61% of the 58 holdings in the SEQI portfolio. This is up from 47% eight months ago.
Floating rate bonds - whose coupons rise and fall with interest rates - make a lot of sense for investors now rates are finally moving off their post-crisis lows. Not only does their income from ‘floaters’ increase, but the capital value of their investments also holds up as yields rise, a defensive feature that does not apply to conventional fixed interest bonds whose prices move in the opposite direction to interest rates.
Nevertheless, upping the exposure to floating rate bonds is not the no-brainer it may first appear. This is because Sequoia is generally not buying its bonds on the open market but instead is lending shareholders’ money to individual companies. Cook and the team therefore have to calculate if the floating debt they could create is sustainable for their borrowers particularly if interest rates rise further than expected.
‘Why should I lend a floating rate to someone who may default? Maybe it’s better to lend to them fixed,’ he said.
Like many bond fund managers, Cook ensures the fixed-rate loans he does hold have shorter terms to reduce their vulnerability to rising interest rates. The SEQI portfolio has a ‘modified duration’ of 1.8 which means that for every 1% increase in interest rates, its net asset value falls 1.8%. ‘That’s quite low sensitivity,’ he explained.
Diversification is another key defence with SEQI’s loans spread across transport, utilities, power, including renewables, technology, telecoms and student accommodation.
The latter raises the issue of construction risk to which no more than a fifth of the fund can be exposed. Building infrastructure and being involved in the early stage of a project is where most of the dangers lie for investors, said Cook. SEQI therefore limits itself to relatively easy construction such as adapting buildings for students which, as he put it, involves ‘internal walls and some plumbing’, not complex and lengthy developments.
Geographical diversification is important too with the UK currently accounting for 28% of assets, followed by 24% in northern Europe and 7% in Australia and New Zealand.
That said, Sequoia has a strategic target to increase its exposure to the US, where president Trump has highlighted a $2 trillion infrastructure funding gap that the firm would like to help fill. Currently 41% of the portfolio is in loans to US projects, an amount that could reach 60% after the company raised the cap on its allocation from 50% last year.
Cook likes the US because American banks are relatively disinterested in infrastructure lending. The lack of competition means Sequoia can lend at higher rates of interest and on better loan terms than it can in Europe.
International exposure brings with it currency risk which Sequoia hedges back to sterling, to protect the fund’s NAV, which he says is a price worth paying.
Join the club
As the company and the fund grow, Sequoia is increasingly finding itself involved in ‘club’ deals when it joins two or three lenders to make big loans to big companies. For example, in the UK it was one of four lenders advancing £100 million of ‘mezzanine’ debt, a form of second mortgage, to Welcome Break.
‘You get better quality deals on larger loans. Bigger companies tend to have better management too so that’s another safeguard,’ he said.
Sequoia Economic Infrastructure Income is also getting bigger - and with a portfolio that this year is expected to generate over £175 million of cash that it can re-lend at higher interest rates - its performance may be getting better too. Over three years, it has generated a 20.7% total return on net assets which has converted to a 14.5% total return to shareholders. Most of the return has come through dividends with the share price rising just 4.5% or 4.5p from 100p at launch three years ago.