1875 Spring 2023 Private Clients

1875

POWERING OPPORTUNITY

FINDING SUSTAINABLE YIELDS IN RENEWABLE INFRASTRUCTURE THE HUNT FOR YIELD

IS DIVIDEND INVESTING A GOOD STRATEGY? AN INVESTMENT TRUST OVERVIEW

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Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned

“Renewable investing has experienced exponential in recent times, attracting significant investment institutions and governments. Retail investors these assets and we explore some of the wind-focused generation strategies on offer that enable access and diversified income streams.”

POWERING OPPORTUNITY

ALASTAIR POWER | INVESTMENT RESEARCH MANAGER

In the wake of the Global Financial Crisis and the subsequent near zero interest rate environment of many Western economies, income investors faced a difficult time in their hunt for income. Many traditional investments like retirement annuities and government bonds soon became unattractive in their returns. Some investors subsequently moved into riskier areas of the financial markets to generate their income, while others adopted the swathe of new alternative investment strategies offered by asset managers. In this issue, we explore the moves taken by investors to generate income in a near zero interest rate world, the importance of a growing yield, generating sustainable incomes through renewables and some of the fund structures on offer in the market.

Following interest rate increases, many may be attracted to 4% cash ISA rates, raising the question of why enter the financial markets for a similar yield but exposure to volatility? On a simple yield comparison of 4% in the safety of a bank or a 4% dividend paying company, choosing the former is fair. But what if the dividend payment is growing at 5%? On a £1,000 pot, the 4% in the bank would generate £40 of income and payback the initial £1,000 of capital in 25 years. That same pot invested in a 4% yield growing at 5% would generate £40 of income in the first year, but through growth of income would pay initial capital back in 17-years, leaving the investor holding the asset and a yield on initial investment of 9.2% at that 17-year payback point. When broken down in this manner, the income growth rate is undeniably a powerful tool over the long run but requires alignment with risk levels and investment time horizon. The pros and cons of focusing on dividend growth and high yield are explored later.

Renewable investing has experienced exponential growth in recent times, attracting significant investment from institutions and governments. Retail investors have access to these assets and we explore some of the windfocused power generation strategies on offer that enable access to sustainable and diversified income streams. Multiple streams of revenue underpin

the returns of wind turbines that have enabled two of the listed investment vehicles to announce dividend increases in-line with inflation in recent months.

Many retail client portfolios display the similar trait in having a mix of direct positions in equities and bonds alongside positions in collectives, either open or closed-end structures. Within Collective Investment Schemes (CIS), different structures have their own pros and cons for income-focused strategies. While open-end funds are required to distribute all their generated income and provide ample liquidity to meet redemptions, closed-end funds have an edge, able to hold illiquid assets and retain dividend reserves to enable the smoothing of income distributions over time. In this edition, we’ll have a quick look at some of the strings able to be pulled within the closed-end investment trust structure, the benefits, and the drawbacks.

With interest rates expected to plateau in 2023, asset prices are reasonably expected to stabilise as investors begin to assess the impact of higher interest rates on corporate profitability. The volatility experienced through the last calendar year has presented opportunities for income investors looking for yields at a bargain. If prepared to withstand some volatility, high quality growing revenue streams are currently on sale.

exponential growth investment from investors have access to wind-focused power access to sustainable streams.”

FINDING SUSTAINABLE YIELDS IN RENEWABLE INFRASTRUCTURE

THE UK HAS QUIETLY BECOME ONE OF THE RENEWABLE POWER LEADERS

JAMES EADES | INVESTMENT RESEARCH

Sustainable investing has risen in prominence in recent years with substantial capital flowing into the renewable energy generation sector. As availability of alternative investment products increased, retail investors have found themselves able to participate in the sector’s growth as portfolios of wind, solar and battery storage assets became available through listed investment companies. Many started using these products as a method of generating diversified and attractive incomes, alongside a desire for environmentally conscious investment.

Through the last two decades, the UK has quietly become one of the leaders in renewable power generation and a global leader in offshore wind with some 2,652 turbines on 43 farms. Contributing 26.8% of the UK’s total electricity generation in 2022 alone and breaking a record by generating 70% of a single day’s total electricity in the month of November 2022, it is now seen as a key component to the achievement of the UK’s 2050 net-zero target.

It may come as no surprise to find the asset management industry at the heart of wind farm ownership with considerable capital flowing into the asset class in recent years. Not exclusive to the sizeable institutional investors, retail investors can participate in the UK’s growth of wind power generation through a selection of three listed investment trusts, among other vehicles. With two of the three generating positive returns in a difficult 2022 and all three recently announcing increased target dividends for the coming years, two in-line with inflation, their potential to generate sustainable and growing incomes is evident.

How these assets generate revenues can be described simply as selling generated electricity into the grid network at contracted pricing agreements. The mechanisms underpinning this, however, are somewhat more complex and split across government subsidies and open market power prices.

Government subsidies remain the key revenue generator for these assets, split across Renewable Obligation Certificates (ROCs) and Contracts for Difference (CfDs). Assigned to the assets upon completion for a period of fifteen to twenty years with inflation linkage embedded in the agreement, ROCs have been a valuable subsidy in recent years given their ability to be traded or submitted to the regulator for payments should capacity levels be met. Perhaps they’ve been

too valuable given the closure of the scheme in 2017 for new generation assets, but they’ll continue to provide inflation linked returns until they expire which will likely be well into 2030. CfDs, on the other hand, provide generators with a smoothing mechanism in the face of volatile wholesale power prices. Below a lower band, price generators receive subsidies but exceed the top band price, the generator is required to pay the government a significant slice of the excess revenues. At the height of the 2022 energy crisis, this mechanism was expected to result in generators paying the government back some £660m.

Away from government subsidies, revenues come in the form of Purchasing Power Agreements (PPAs) or longterm contracts for energy supply at agreed upon prices between supplier and purchaser. This enables companies the opportunity to lock in prices and ensure energy is sourced by renewable means in-line with their own corporate

(UKW) all provide access to a split of offshore and onshore wind assets and a primary focus in the UK. There are, however, some differences with ORIT and TRIG offering marginal exposure to alternative technologies, such as batteries and solar, and European located assets, compared to UKW’s sole focus on UK wind. Construction remains the greatest differentiator, though, with ORIT leaning into the deep bank of industry experience within the team to enhance generation capacity and hence returns through construction over the purchase of already completed assets. While a risk in its own right, constructing the farms does limit exposure to the competition in bidding processes for completed assets.

Focusing on the bigger picture of understanding the tailwinds behind wind power in the long term - with plans to increase offshore wind output by a multiple of five by 2030 - and the mechanisms underpinning revenue generation within these assets is arguably the best approach to initially

sustainability targets. It is expected the contracts will form a larger part of the revenue mix over the next fifteen years, but how government subsidy programmes will evolve remains unclear.

Three investment options exist within the space. Octopus Renewables Infrastructure Trust (ORIT), The Renewables Infrastructure Group (TRIG) and Greencoat UK Wind

assess the sector. Once achieved, the intricate difference between the portfolios on offer can become a larger focus. However, as we carve up our assessment of wind assets, there is a possibility that these assets could provide a sustainable yield given the backing afforded by subsidies alongside the conscience of participation in an environmentally friendly solution on the path to net-zero.

THE HUNT FOR YIELD

GREG LODGE | PERFORMANCE & RISK ANALYST

In 1999, Japan experienced an unusual and unprecedented event, becoming the first country to experience zero interest rates on the back of deflationary issues within its economy. Initially viewed by many as an isolated event for a country struggling with an ageing population and declining corporate profitability on the back of falling prices, zero rates were considered unthinkable in other developed nations. As we would later learn, an era of interest rates at zero percent became the reality.

As the Global Financial Crisis sent stock markets plunging, central banks raced to slash interest rates in a bid to stabilise the economy. The Bank of England would cut the base rate eight consecutive times until, by March of 2009, it was sitting at 0.50% where it would stay for the coming decade, occasionally moving higher, but ultimately declining again at the hands of COVID -19. Last year saw the start of a repeated hiking of the base rate in response to inflation, currently at 4.25% after ten consecutive raises. The 13 years of interest rates at near-zero would impact every asset class and income investors would have to get creative in the hunt for yield.

100-year 2017 bond issue, offered a coupon of 2.1% with significant interest rate risk that saw the price rise from €100 to €220 in the first three years as interest rates fell. But with rates higher, the price currently sits around the €70 mark.

To generate yield for income portfolios, adjustments were required. The period saw a growth in the popularity of bondproxies – relatively stable income producing assets but with limited or no growth in the yield distribution. Infrastructure funds such as HICL and Greencoat UK Wind offered attractive yields with a degree of security, as cashflows are often government backed. REITs (real estate investment trusts) became a useful income-generating asset for portfolios with some of the higher yielding options attracting significant retail investor attention.

Record-low annuity rates created another challenge for pension income. Annuity rates are closely linked to 15-year government gilt yields. An increase or decrease in the yields of these gilts significantly affects the yields available on standard annuities. According to a website, a level annuity for a 65-year-old bought for £100,000 pre-financial crisis in March 2008 would offer a yearly income of c.£7,740. By August 2016, the same sum would yield only £4,696 – an all-time low. The return of higher interest rates and yields on gilts has seen the income on the hypothetical annuity recover to almost pre-financial crisis levels, with £6,852 quoted.

With little-to-no yield to be had from fixed interest or bank deposits and so much cheap borrowing available, assets ranging from equities to property reached historic valuations. Property assets within the supply constrained industrials sector experienced significant capital gains as yields declined and high growth companies were the popular place to be. Financial professionals banded the phrase ‘There Is No Alternative’ (TINA), implying equities were the only game in town but, after recent interest rate increases, TINA looks to be no-longer.

As interest rates have begun to rise again, a ‘normalisation’ of yields could be said to have emerged. Income-seeking investors no longer have to pile into more speculative debt in their search for returns.

By August 2019, low yields across the quality spectrum of corporate bonds had become an everyday fact of life. So compressed had the yield become that a quarter of the global bond market traded at a negative inflation adjusted yield. If held to maturity, investors were guaranteed to make a loss in real, or inflation adjusted, terms. According to Intercontinental Exchange, bonds with yields of more than 10% made up just 0.4% of global bond markets. Fixed income investors began searching for yield in riskier areas of markets, heading into lower quality bonds of companies and governments. Two individual bond issues potentially highlight investor appetite for risk in the zero-rate world. In early 2019, Uzbekistan issued its first bond, aiming to raise US$1bn, and investor demand exceeded the US$6bn mark in their efforts to chase a 4.75% yield. The second, Austria’s

As the pendulum of monetary policy in developed economies swings the other way after more than a decade, trends that have become entrenched are unwinding. Yields on investment grade government and corporate bonds are looking much more attractive, along with other areas of the market. Many investors will now be considering how to re-adjust their portfolios in the new environment. While the question remains as to where inflation will go and how central banks will wrestle with it, new opportunities have emerged in the hunt for attractive income streams.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.

Infrastructure funds such as HICL and Greencoat UK Wind offered attractive yields with a degree of security, as cashflows are often government backed. REITs (real estate investment trusts) became a useful income-generating asset for portfolios with some of the higher yielding options attracting significant retail investor attention.

TOPIC OF THE MONTH

IS DIVIDEND INVESTING A GOOD STRATEGY?

STEPHEN DONE | INVESTMENT RESEARCH

Market turmoil, rising recession fears and increasing concerns for the global economic outlook have left many investors looking for ways to defend their portfolios while searching for potential pockets of upside. One investing strategy that is proving popular with factors like market volatility, inflation, and rising rates currently present is dividend investing, the process of investing in dividendpaying companies that have historically provided both reliability and growth over time.

Two common approaches to this strategy are targeting either dividend growth or a high dividend yield. Dividend growth investing focuses on identifying companies that have a track record of increasing their dividend payments annually, while high dividend yield seeks out companies that pay a high percentage of their earnings as dividends. Both approaches have their merits, but what makes these methods so attractive to investors? In this article, we will explore the pros and cons of targeting dividend growth versus high dividend yield.

Dividend growth investing focuses on companies that consistently increase their dividend payouts over time and can provide investors with a steady source of cash. These

dividend-growing corporations are typically well-established, soundly managed companies with a solid financial foundation, a long track record of profitability and are typically viewed as less risky investments. These corporations tend to have stable earnings, consistent cash flows, a longterm growth plan and a commitment to returning value to shareholders. They also tend to experience durable competitive advantages, diversified revenue streams and strong balance sheets that allow for continued revenue growth throughout the complete market cycle.

Dividend aristocrats are a perfect example of these ‘dividend growers.’ These companies have a strong track record of steadily raising their dividend payments to shareholders, with requirements for a company needing to have raised its dividends for at least 25 years in a row and be included in the S&P 500 index to qualify for the title. Some examples of these companies include Coca-Cola, McDonald’s, and Exxon Mobil.

But what is the attractiveness of these dividend growers to investors? Companies that concentrate on consistently increasing dividends typically have higher-quality, cash-rich

operations that perform well in both up and down markets. Dividend payments can also act as a buffer for investors, helping to offset losses in times of market declines while providing excess returns throughout the rest of the market cycle. For income-focused investors, these companies can also provide a long-term consistent flow of dividends, while providing the potential for consistent capital appreciation and can prove effective as essential defensive holdings within a portfolio.

High dividend yield investing, on the other hand, focuses on generating a steady stream of income from dividend payments, rather than solely relying on capital appreciation. The strategy targets businesses that offer attractive higherthan-average dividend yields. These corporations are typically highly established companies that have betterdeveloped business models, steady and predictable cash flows and typically depend less on expansion to produce returns. High dividend payers have traditionally been found in the materials, utilities, and consumer staples sectors, as companies in these spaces generally provide goods and services with relatively inelastic demand.

However, investors should be wary of chasing high dividend stocks as all might not be as it seems. Most high dividend yields are also typically artificially high due to falling stock prices or other monetary problems, with these companies offering a lower prospect of capital growth for the portfolio. Investors also need to consider the repercussions of a business which distributes a large portion of cash generated to investors, with a lack of reinvestment into the business undermining its long-term prospects. This may result from a lack of attractive reinvestment opportunities, with excess cash therefore used to attract new investors, creating demand, and raising the price of their stock. As a result, analysis of the sustainability of the business model and the underlying financial performance is key for investors wanting to avoid businesses that carry the greatest risks, while considerations regarding the value of the underlying business and prevailing market conditions are key.

Let us take a look at a numerical example. An investor is considering the purchase of two different stocks, where Stock A is a high dividend-yielding business and Stock B is a dividend grower. If the investor wants to purchase two hundred shares of Stock A priced at £25 per share, they will incur a £5,000 initial investment. The stock in question pays an annual dividend of £1.13 per share (dividend yield of 4.5%), with the investor expecting a total return in dividend payments of £226 in the first year. If you were to disregard capital appreciation and assume that the dividend stream is continuous without growth, the payback period on the investment is 22 years. The payback period is the length of time it takes for the cash inflows generated by the investment to equal the initial investment which, when calculated, can help to establish a baseline performance or worst-case scenario.

However, if we were then to compare this to Stock B that is also priced at £25, with an initial annual dividend payment

per share of £0.75 (dividend yield of 3%) the first-year total dividend returns would equal £150. Nevertheless, if this dividend growth stock managed to grow its dividend stream at just 5% annually, the investor would recoup the whole initial investment in just 20 years. In other words, the payback period for the dividend growth stock would be two years shorter. This dividend payback matrix model does make an assumption that the expected dividend growth is consistent throughout the period but can still be used to highlight the power of compounding dividend growth.

This numerical example can also be used to highlight some of the key strengths of high-yield dividend investing. The initial income generated by the investment in Stock A is significantly higher than Stock B. In fact, the total annual income generated is greater than Stock B for the first 11 years. High yield investing can provide investors with a significantly larger income stream annually which can, depending on the investor’s objectives, either be reinvested or taken out.

When taking a look back at the previous 45 years, companies that have consistently grown their dividends have been lead performers in the market, including when compared to other companies that simply maintain payments. Additionally, the outperformance has been achieved while also demonstrating lower volatility of returns, providing a more stable investing experience for investors. During periods of market uncertainty, the predictable nature of the businesses’ earnings and cash flows can make the stock less volatile, less exposed to sell offs and more recession resistant.

The defensive characteristics that are shown by these companies by being able to maintain and grow dividends throughout challenging periods can result in them being a critical allocation for investors. Companies with consistent cash flows and strong pricing power tend to be better positioned than competitors to maintain margins in the face of rising costs and interest rates. Due to their relative stability, absolute returns of defensive, dividend-paying companies have performed better than the S&P 500 Index during economic downturns, periods of high inflation as well as the previous six rate hike periods since the 1980s.

In conclusion, both dividend growth and high dividend yield investing have both their merits and shortcomings. Dividend growth investing can provide investors with a growing income stream over time, while high dividend yield investing can offer investors a significant income stream in the short term. Ultimately, the best approach will depend on the investor’s goals and risk tolerance. Investors seeking long-term growth and stability may prefer dividend growth investing, while those seeking a high-income stream may prefer high dividend yield investing.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.

AN INVESTMENT TRUST OVERVIEW

Investment trusts are nothing new. In fact, some of the oldest have been around for over a century, with the likes of Scottish Mortgage and Witan founded in 1909. At present, 450 of these companies are listed on the London Stock Exchange with a combined market capitalisation of some £260bn. While sizeable, this figure is dwarfed by the £1.4tn of assets held within Investment Association covered retail funds.

Going through the same launching process as any listed company, the Initial Public Offering (IPO) acts as the first round of fundraising from which money raised is invested into a pool of assets, the performance of which drives the company’s earnings and thus the share price over time. Unique to the UK, the valuations of these companies are generally valued through the comparison of the share price to the Net Asset Value (NAV) per share, with a share price premium to NAV seen as expensive and vice versa.

Multiple benefits exist as a result of the listed investment trust structure, from an independent board looking after shareholder interests, accessing illiquid assets unable to be held in open-end funds, smoothing of dividends and the use of borrowing to enhance returns. While

all beneficial there are some drawbacks in the form of greater volatility and a smaller investable universe.

Independent boards of directors are often seen as a key benefit of investment trusts. Elected to look after operations of the company, from the management of the assets to dividend policy, these often highly experienced industry professionals offer an extra layer of governance to ensure shareholder interests are being met.

Likely to be the greatest benefit of the investment trust’s permanent capital structure is their ability to hold illiquid assets. Unlike open-end funds which must provide liquidity to investors at regular intervals, investment trusts permanent capital base prevents this issue. As a result, they can hold highly illiquid assets, providing investors access to a diverse range of assets from wind farms to private loans. With the shares trading on recognised exchanges, investors can gain exposure to illiquid assets with the liquidity of holding a share listed on a recognised exchange.

For income investors, the investment trust has some particularly valuable tools at their disposal. While openend funds are required to distribute 100% of their net income, investment trusts are only required to distribute 85%, enabling retention of income reserves able to be

ALASTAIR POWER | INVESTMENT RESEARCH MANAGER

later released to smooth and grow the dividend over time. These reserves can become significant with the likes of Merchants Trust (MRCH) holding more than 50% of the target dividend in reserve. The ability to draw down from this pot, as happened through 2020 when dividends were suspended by many companies, enables consistency of income and its growth for investors. Through time this has considerable benefits with the likes of MRCH and City of London Investment Trust (CTY) growing their dividends for 41 and 56 consecutive years, respectively. To highlight the scale of this, a £1,000 initial investment in CTY at the beginning of the 56-year period would have generated £45,600 of income over the period compared to just £3,700 from a savings account. Admittedly a highly unlikely holding period for any investor, this highlights the power of compounded dividend growth over long time horizons.

base, the capacity enables an uplift in returns without significant increases in risk. Beneficiaries are mostly found in the real assets space where the higher levels of borrowing are generally found.

While the benefits are abundant, drawbacks remain. Most notably in the form of limited options in some of the more popular sectors alongside the potential for greater volatility.

In the UK equity income sector alone, the 74 open-end constituents vastly outnumber the 20 investment trusts on offer. The US-focused sector shows a much starker difference with just seven options in the North America Investment Trust sector against more than 250 options in the IA North America sector. Options are therefore thin in some of the larger sector allocations seen within client portfolios.

Increased volatility is likely to be the largest negative of the investment trust structure, with borrowing having the potential to increase gains and losses alongside the enhanced price swings of a trust moving from a trading premium to a discount around the performance of the asset portfolio. In times of market stress, investors are prone to dispose of their most liquid assets, increasing the probability for falls in an investment trust’s share price to exceed that of the underlying portfolio of assets, or NAV. While an issue for current holders, it creates opportunities for cash heavy investors seeking out a bargain.

While investment trusts don’t suit every investor portfolio, they can play a valuable role in portfolios. Currently trading at the widest discounts seen since the financial crisis, there looks to be some attractive opportunities in the space.

The capacity to deploy gearing, or borrowing, by an investment trust provides another advantage of the structure over their open-end peers. By borrowing and investing at higher rates of returns, the company has the capacity to generate further returns on the underlying assets. Generally limited to 30% of the asset

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.

The capacity to deploy gearing, or borrowing, by an investment trust provides another advantage of the structure over their openend peers. By borrowing and investing at higher rates of returns, the company has the capacity to generate further returns on the underlying assets.