Even after June's better-than-expected inflation figures, core UK inflation remains high, which suggests higher interest rates for longer. Commentators are expecting that the base rate, which at 5.25% is at its highest for over 15 years, is likely to peak around 5.75%.
This would bring even more pain for mortgage borrowers and greater government borrowing costs to an already faltering economy.
The Bank of England's job 'is not done' yet after 25bps hike
Part of the reason inflation has remained high relates to the pandemic. Some workers left the workforce permanently, reducing the talent pool, which has helped sustain higher employment levels and has put upward pressure on wages (regular average seasonally adjusted weekly pay increases are running at about 7.3%, according to the ONS).
Some observers think that wage inflation has not peaked. Above target inflation and consequently higher interest rates are likely to persist for some time. Investors, particularly those in search of income, will have to adjust to this.
Against this backdrop, we have been screening the market for funds that offer a decent yield that have also provided superior long-term total returns, and the infrastructure and renewables sectors stand out as being particularly interesting.
Both sectors offer decent yields (medians of 5.9% and 6.7% for infrastructure and renewables respectively), with decent long-term returns (a median of 8.8% NAV total return per annum for infrastructure over ten years and a median of 10.8% for renewables over five years) and are available at significant discounts to NAV (a median of 19.2% for infrastructure and 18.4% for renewables).
It should be noted that both sectors fell sharply on the back of rising interest rates and, while they have bounced back a bit, look cheap relative to history, despite tending to have strong revenue visibility with a high degree of inflation linkage.
For the yield requirement, we looked at funds that provide a yield in excess of 6% on the basis that it is what can currently be achieved on bank deposits.
Bank of England hikes rates by 25bps to 5.25%
For the total return requirement, we used a total return in excess of 6% per annum, taken over ten years where available, or five years if a fund's life is shorter.
The aim of using the long-term numbers is to smooth out the effects of the pandemic and, to a lesser extent, the fallout from the referendum, which still distorts five-year numbers, where possible.
Looking at the infrastructure sector, three funds make the cut: GCP Infrastructure, HICL Infrastructure and International Public Partnerships, all of which are quality well-managed funds with long track records. Of these, GCP Infrastructure stands out as having a dividend yield at 9.2%, which is well above the sector median of 6.7%.
It has provided an NAV total return of 8.5% per annum over ten years and is available at a 31% discount to NAV.
GCP has been able to take advantage of higher rates when making new investments, but the manager has not focused purely on yield and has also put aside some of the extra return to improve the quality of its investments. GCP also captures some of the theme discussed below as it has a high renewables exposure.
Looking at the renewables sector, two funds with a lifespan that exceed ten years make the cut: Bluefield Solar and The Renewables Infrastructure Group (TRIG).
Bluefield Solar comes with a yield of 7.2% and a track record of 10% per annum NAV total returns.
It can be bought on a 16.0% discount, when it consistently traded at a premium for many years. It has benefited recently from diversifying into wind generation, which is highly complementary to solar).
TRIG also has a mix of wind and solar. Its NAV returns are not quite as good (9.2% per annum over ten years) and at 6.3% its yield is lower.
Taking a five-year horizon and there is a wealth of funds that clear our hurdles: Foresight Solar, Gore Street Energy Storage, Greencoat Renewables, JLEN Environmental Assets, and NextEnergy Solar. These are all good funds that offer differing propositions, and diversification within this space is key.
At 8.9%, NextEnergy Solar offers the highest yield of this group. Moreover, it recently hiked its dividend target for this year by an inflation-matching 11% and is confident that this will be well-covered by earnings.
The best-performing of these funds over five years is JLEN Environmental Assets, which has generated an average annual NAV total return of 11%. It also benefits from having a particularly diverse portfolio.
All of these funds come with the added bonus of strong ESG credentials as, particularly in the renewables space, they're doing great work to help fight against climate change.
Matthew Read is senior analyst at QuotedData