Investment companies in the AIC’s Infrastructure sector trade at an average premium of 15.6 per cent, the Renewable Energy Infrastructure sector stands at a 16 per cent premium, and while the UK Commercial Property sector is on a discount of 8.8 percent, those REITs within it that invest in warehouse properties alone are at premiums of between 1.6 per and 5.8 per cent.
For context, the average investment company trades at a 4 per cent discount.
Another round of suspensions for open-ended property funds this year has once again hammered home the liquidity mismatch in the sector, while closed-ended equivalents have remained open for trading.
Less liquid assets, such as property and infrastructure assets, have the potential to produce higher levels of income because of the illiquidity premium.
They are particularly well suited to holding within closed-ended investment companies because assets do not have to be sold when investors sell their shares, enabling portfolio managers to take the long view.
Infrastructure and property investment companies typically yield between 4 per cent and 6 per cent, with income streams often secured by long leases or government contracts.
“Jam today”: income from capital profits
The third feature of investment companies that is useful for income generation is the ability to pay income out of capital profits.
There is a philosophical debate about this which mirrors the debate between ‘natural income’ and ‘safe withdrawal rates’ in the adviser world.
Historically, investment trusts were not able to do it; this changed in 2012, but only a minority have taken advantage of these new freedoms.
These companies have responded to shareholder demand by topping up their ‘natural’ dividends with distributions from capital.
Generally speaking they have been rewarded by seeing their discounts narrow or even move to premiums in some cases.
It is worth taking a moment to understand how this works.
Let’s say you launch a brand-new investment company with assets of £100m.
In a year’s time, those assets have produced income of £2m, which you pay out in full as dividends to your shareholders.
In the meantime, the value of the assets has also grown to £105m.
That gives you £5m of capital profits which could potentially be distributed, either immediately or in future, if the investment company’s articles of association allow.
One advantage of paying dividends from capital profits is that you can produce income from asset classes that naturally generate little or none: private equity, for instance, or smaller companies. This enables income investors to diversify their portfolios away from the likes of Shell or HSBC.
Another potential benefit of allowing distributions from capital is that you reduce the pressure on the portfolio manager to invest in higher yielding assets when she or he sees better opportunities elsewhere.
