Confused about discount rates in infrastructure funds

Hi everyone, I am still learning some of the fundamentals in investing. In particular now I am a bit unsure about why an increase in discount rates leads to a drop in NAV for an infrastructure trust (and possibly other trusts too). I read this article:
https://citywire.com/investment-trust-insider/news/discount-rates-why-are-infrastructure-funds-falling/a2398279

I'm not very familiar with discount rates, but my understanding is it's the opposite of compounded interest rate, e.g., it tells you how much a pot of money should be now so that it reaches X amount in the future. The article says it has two components:
"There are two components to the discount rate. There is the risk-free component (typically government bond yields that provide compensation for waiting – i.e. the time value of money) and there is the risk premium component (the element that reflects the risk of default or delay on the underlying cashflows)."

The following is from the HICL Infrastructure (HICL) annual report 2022: "The discount rate is determined based on the Investment Manager’s knowledge of the market, which includes intelligence gained from bidding and disposal activities, discussions with financial advisers knowledgeable of these markets and publicly available information on relevant transactions."
So then it is an estimation set by the company (probably due to the risk premium component above).

From the table in the citywire article above it results that a larger discount rate leads to a reduction in NAV, suggesting a negative impact on the trust (which would also explain an unprecedented 9% plunge in value today for HICL).  Something does not make sense in my mind though, as the way I see it is a higher discount rate would mean its current value would be boosted in the future, so it should have a positive outlook. I would appreciate if someone could clarify this. Thank you!


Comments

  • Linton
    Linton Posts: 18,054 Forumite
    Part of the Furniture 10,000 Posts Name Dropper Hung up my suit!
    edited 27 September 2022 at 6:18PM
    A discount rate is used to determine the current value of future income.  Say someone offers to give you £1000 in 10 years time.  How should you value that now?

    Clearly it is not worth £1000 now because if you had £1000 now you could buy safe 10 year bonds at say 2.5% and so in 10 years time your money would be worth around £1280. So one measure is what lump sum now would gve you £1000 in 10 years time at current safe interest rates.  That works out to be about £780.  That represents the time component.

    Now perhaps you suspect the person making the offer will not actually come up with the money in 10 years time.  So you may wish to change your £780 valuation further to take account of this by reducing it by some %.  This is the risk premium.

    These considerations are important for Infrastructure companies as they borrow a lot of money to build the infrastructure and get paid back over an extended time period.  WIth interest rates rising the current value of their future income looks less attractive.


  • MarcoM
    MarcoM Posts: 802 Forumite
    Part of the Furniture 500 Posts Name Dropper Combo Breaker
    Hi everyone, I am still learning some of the fundamentals in investing. In particular now I am a bit unsure about why an increase in discount rates leads to a drop in NAV for an infrastructure trust (and possibly other trusts too). I read this article:
    https://citywire.com/investment-trust-insider/news/discount-rates-why-are-infrastructure-funds-falling/a2398279

    I'm not very familiar with discount rates, but my understanding is it's the opposite of compounded interest rate, e.g., it tells you how much a pot of money should be now so that it reaches X amount in the future. The article says it has two components:
    "There are two components to the discount rate. There is the risk-free component (typically government bond yields that provide compensation for waiting – i.e. the time value of money) and there is the risk premium component (the element that reflects the risk of default or delay on the underlying cashflows)."

    The following is from the HICL Infrastructure (HICL) annual report 2022: "The discount rate is determined based on the Investment Manager’s knowledge of the market, which includes intelligence gained from bidding and disposal activities, discussions with financial advisers knowledgeable of these markets and publicly available information on relevant transactions."
    So then it is an estimation set by the company (probably due to the risk premium component above).

    From the table in the citywire article above it results that a larger discount rate leads to a reduction in NAV, suggesting a negative impact on the trust (which would also explain an unprecedented 9% plunge in value today for HICL).  Something does not make sense in my mind though, as the way I see it is a higher discount rate would mean its current value would be boosted in the future, so it should have a positive outlook. I would appreciate if someone could clarify this. Thank you!


    Hello, do you think HICL will recover at some point? 
    9% is one he'll of a crash for this trust in only a few hours. 
  • Linton said:
    A discount rate is used to determine the current value of future income.  Say someone offers to give you £1000 in 10 years time.  How should you value that now?

    Clearly it is not worth £1000 now because if you had £1000 now you could buy safe 10 year bonds at say 2.5% and so in 10 years time your money would be worth around £1280. So one measure is what lump sum now would gve you £1000 in 10 years time at current safe interest rates.  That works out to be about £780.  That represents the time component.

    Now perhaps you suspect the person making the offer will not actually come up with the money in 10 years time.  So you may wish to change your £780 valuation further to take account of this by reducing it by some %.  This is the risk premium.

    These considerations are important for Infrastructure companies as they borrow a lot of money to build the infrastructure and get paid back over an extended time period.  WIth interest rates rising the current value of their future income looks less attractive.


    Thanks for clarifying this. So to continue with your example, in this case even if the infrastructure company now has a debt of £600 (using small numbers for simplicity), they might have to pay back £1000 in 10 years including time component and risk premium, and this would decrease the NAV (which is assets - liabilities)? So then "discount rate" refers to the debt rather than the portfolio?

    However, the citywire article also says that "The average discount rate for the HICL Infrastructure (HICL) portfolio, for example, was 6.8% in the company’s last set of results in June. Another way of looking at this is that if everything goes according to plan (based on management assumptions about the income it receives, economic conditions, etc), the portfolio will grow by 6.8% over the next year."
    So then the portfolio grows by the discount rate, rather than becoming smaller. Doesn't that mean NAV grows? Thanks!
  • MarcoM said:
    Hi everyone, I am still learning some of the fundamentals in investing. In particular now I am a bit unsure about why an increase in discount rates leads to a drop in NAV for an infrastructure trust (and possibly other trusts too). I read this article:
    https://citywire.com/investment-trust-insider/news/discount-rates-why-are-infrastructure-funds-falling/a2398279

    I'm not very familiar with discount rates, but my understanding is it's the opposite of compounded interest rate, e.g., it tells you how much a pot of money should be now so that it reaches X amount in the future. The article says it has two components:
    "There are two components to the discount rate. There is the risk-free component (typically government bond yields that provide compensation for waiting – i.e. the time value of money) and there is the risk premium component (the element that reflects the risk of default or delay on the underlying cashflows)."

    The following is from the HICL Infrastructure (HICL) annual report 2022: "The discount rate is determined based on the Investment Manager’s knowledge of the market, which includes intelligence gained from bidding and disposal activities, discussions with financial advisers knowledgeable of these markets and publicly available information on relevant transactions."
    So then it is an estimation set by the company (probably due to the risk premium component above).

    From the table in the citywire article above it results that a larger discount rate leads to a reduction in NAV, suggesting a negative impact on the trust (which would also explain an unprecedented 9% plunge in value today for HICL).  Something does not make sense in my mind though, as the way I see it is a higher discount rate would mean its current value would be boosted in the future, so it should have a positive outlook. I would appreciate if someone could clarify this. Thank you!


    Hello, do you think HICL will recover at some point? 
    9% is one he'll of a crash for this trust in only a few hours. 
    That's one of the things I'm trying to grasp, the other infrastructure companies also bled a lot today, even though not as badly.
  • Prism
    Prism Posts: 3,845 Forumite
    Seventh Anniversary 1,000 Posts Name Dropper
    For many it won't matter what the share price of something like HICL is as they bought it for the index linked dividends. The only thing to ask really is how much is a trust that pays over a 5% dividend (as of today) vs a 1 year savings account which pays a risk free 4% actually worth.
  • Prism said:
    For many it won't matter what the share price of something like HICL is as they bought it for the index linked dividends. The only thing to ask really is how much is a trust that pays over a 5% dividend (as of today) vs a 1 year savings account which pays a risk free 4% actually worth.
    It matters if you buy now because now at the new price that same dividend is 5.45%. And can you please share which account you've seen with 4% interest in the uk for 1 year? Thanks!
  • Prism
    Prism Posts: 3,845 Forumite
    Seventh Anniversary 1,000 Posts Name Dropper
    Prism said:
    For many it won't matter what the share price of something like HICL is as they bought it for the index linked dividends. The only thing to ask really is how much is a trust that pays over a 5% dividend (as of today) vs a 1 year savings account which pays a risk free 4% actually worth.
    It matters if you buy now because now at the new price that same dividend is 5.45%. And can you please share which account you've seen with 4% interest in the uk for 1 year? Thanks!
    Just on the main page here Savings accounts: 2.5% easy access or up to 4.32% fixed (moneysavingexpert.com)

    Well 3.91% at the moment so not quite 4%
  • Linton
    Linton Posts: 18,054 Forumite
    Part of the Furniture 10,000 Posts Name Dropper Hung up my suit!
    edited 27 September 2022 at 9:03PM
    Linton said:
    A discount rate is used to determine the current value of future income.  Say someone offers to give you £1000 in 10 years time.  How should you value that now?

    Clearly it is not worth £1000 now because if you had £1000 now you could buy safe 10 year bonds at say 2.5% and so in 10 years time your money would be worth around £1280. So one measure is what lump sum now would gve you £1000 in 10 years time at current safe interest rates.  That works out to be about £780.  That represents the time component.

    Now perhaps you suspect the person making the offer will not actually come up with the money in 10 years time.  So you may wish to change your £780 valuation further to take account of this by reducing it by some %.  This is the risk premium.

    These considerations are important for Infrastructure companies as they borrow a lot of money to build the infrastructure and get paid back over an extended time period.  WIth interest rates rising the current value of their future income looks less attractive.


    Thanks for clarifying this. So to continue with your example, in this case even if the infrastructure company now has a debt of £600 (using small numbers for simplicity), they might have to pay back £1000 in 10 years including time component and risk premium, and this would decrease the NAV (which is assets - liabilities)? So then "discount rate" refers to the debt rather than the portfolio?

    However, the citywire article also says that "The average discount rate for the HICL Infrastructure (HICL) portfolio, for example, was 6.8% in the company’s last set of results in June. Another way of looking at this is that if everything goes according to plan (based on management assumptions about the income it receives, economic conditions, etc), the portfolio will grow by 6.8% over the next year."
    So then the portfolio grows by the discount rate, rather than becoming smaller. Doesn't that mean NAV grows? Thanks!

    Prism said:
    For many it won't matter what the share price of something like HICL is as they bought it for the index linked dividends. The only thing to ask really is how much is a trust that pays over a 5% dividend (as of today) vs a 1 year savings account which pays a risk free 4% actually worth.
    Exactly as Prism says...

    Nothing in the Infrastructure company's finance need have changed.  To use made-up figures as I have no idea what the real ones are...

    Suppose the money was borrowed on a fixed 3% interest and the infrastructure contract if operated to plan returns 6%.  That is a nice 3% profit when the best 100% safe option from gilts returned 0.5%.  Now that safe interest rates have go up to 3% why would anyone be interested in a 3% gain with some, possibly small, risk from investing in an infrastructure company?  It is exacrly the same reason why the capital value of bond funds has fallen.  Increasing safe interest rates makes fixed interest returns from old investments less desirable and so their capital value falls to a point where the effective return becomes more worthwhile.

    The discount rate is a measure of this effect.
  • Linton said:
    Linton said:
    A discount rate is used to determine the current value of future income.  Say someone offers to give you £1000 in 10 years time.  How should you value that now?

    Clearly it is not worth £1000 now because if you had £1000 now you could buy safe 10 year bonds at say 2.5% and so in 10 years time your money would be worth around £1280. So one measure is what lump sum now would gve you £1000 in 10 years time at current safe interest rates.  That works out to be about £780.  That represents the time component.

    Now perhaps you suspect the person making the offer will not actually come up with the money in 10 years time.  So you may wish to change your £780 valuation further to take account of this by reducing it by some %.  This is the risk premium.

    These considerations are important for Infrastructure companies as they borrow a lot of money to build the infrastructure and get paid back over an extended time period.  WIth interest rates rising the current value of their future income looks less attractive.


    Thanks for clarifying this. So to continue with your example, in this case even if the infrastructure company now has a debt of £600 (using small numbers for simplicity), they might have to pay back £1000 in 10 years including time component and risk premium, and this would decrease the NAV (which is assets - liabilities)? So then "discount rate" refers to the debt rather than the portfolio?

    However, the citywire article also says that "The average discount rate for the HICL Infrastructure (HICL) portfolio, for example, was 6.8% in the company’s last set of results in June. Another way of looking at this is that if everything goes according to plan (based on management assumptions about the income it receives, economic conditions, etc), the portfolio will grow by 6.8% over the next year."
    So then the portfolio grows by the discount rate, rather than becoming smaller. Doesn't that mean NAV grows? Thanks!

    Prism said:
    For many it won't matter what the share price of something like HICL is as they bought it for the index linked dividends. The only thing to ask really is how much is a trust that pays over a 5% dividend (as of today) vs a 1 year savings account which pays a risk free 4% actually worth.
    Exactly as Prism says...

    Nothing in the Infrastructure company's finance need have changed.  To use made-up figures as I have no idea what the real ones are...

    Suppose the money was borrowed on a fixed 3% interest and the infrastructure contract if operated to plan returns 6%.  That is a nice 3% profit when the best 100% safe option from gilts returned 0.5%.  Now that safe interest rates have go up to 3% why would anyone be interested in a 3% gain with some, possibly small, risk from investing in an infrastructure company?  It is exacrly the same reason why the capital value of bond funds has fallen.  Increasing safe interest rates makes fixed interest returns from old investments less desirable and so their capital value falls to a point where the effective return becomes more worthwhile.

    The discount rate is a measure of this effect.
    Thank you, that makes sense.  A quick question. For HICL it says gearing is at 0%: https://www.theaic.co.uk/companydata/0P00008F9F
    Does that mean there is no borrowing?
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