The Liquid Illiquid Solution
Updated: May 17, 2022
There is little doubt that low interest rates have been causing savers and investors difficulties in recent years. In decades past, not only were interest rates much higher in nominal terms, but they also exceeded the prevailing inflation rate by a decent margin.
"These assets provide inflation protection to varying degrees"
Nowadays, the best interest rate available on an easy access savings account, according to MoneySavingExpert.com, is 1.46%. This rate is not only low in nominal terms, but with inflation at 1.7%, also fails to preserve purchasing power. Long-term interest rates, as represented by gilt yields, are also very low, both in nominal and real terms. This means that achieving decent total returns from gilts will rely on yields falling, in contrast to years gone by when much higher yields meant you could make money even if yields remained static.
Interest rates in the UK and elsewhere are low because economic growth and inflation are currently low. The underlying causes of this weakness are complex, but in a nutshell they relate to changing demographics, rising wealth and income inequality, and falling productivity. These issues are structural rather than cyclical in nature, meaning that they are not going away anytime soon.
One area of the investment universe that has been getting increasing attention recently is illiquid assets that can be accessed via listed and thus liquid investment trusts. Examples include conventional assets such as property and infrastructure, but also less conventional ones such as aircraft royalties and loans. These assets provide inflation protection to varying degrees: infrastructure assets can have pricing structures that are explicitly linked to inflation, while others have little or no protection. Moreover, the assets can be tangible, such as an aircraft, or intangible, as in a royalty.
In addition to tangibility of assets and degree of inflation protection, a third, and arguably the most important, factor is income generation.
Theory says that the return to perpetuity of an asset or investment is equal to the current income - dividend yield - plus the average annual growth over the long term of said income. For income to grow sustainably, the value of the capital that is producing the income must grow.
Thus, if investment B is yielding much less than investment A, capital growth of investment B must be much higher for its total return to keep pace with that of investment A. This, incidentally, is why value investing has significantly outperformed growth investing over the last 100 or so years.
Aircraft, property, royalties, and infrastructure are examples of yielding investments. Aircraft generate lease payments from airlines, while property tenants pay rent. Examples of zero yielding assets include precious metals, art and wine. In fact, they tend to be negative yielding since storage costs must be paid.
Of course, buying income generating assets at the top of the market will likely lead to poor returns, but at least you have the benefit of the yield. Not only will the yielding asset provide income, but the yield itself can also help you gauge whether underlying capital values are high or low - low rental yields in relation to history are often an indication that property prices are too high.
Although listed investment trusts, whether real estate investment trusts or otherwise, provide a liquid pathway to illiquid assets, they are of course subject to discount risk. If there is a surface of sellers, as is the case in stressed markets, you may only be able to sell at a price below the value of the underlying assets.
The solution is twofold. First, try to make sure that you will not be a seller during the next downturn. This means both having a sufficiently long investment time horizon as well as the mental strength to stay calm when others are panicking. Second, try to seek out stable and sustainable income streams, often those that are generated by appropriately financed balance sheets. Such income streams will tend to support capital values, and thus share prices, in the longer term.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.