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30 August 2023

Debt, Deals and Discounts

As we embark on the second half of 2023, we leave a challenging first half behind and head into what is likely to be another difficult period in financial markets. UK inflation remains stubbornly elevated, interest rates are expected to rise further and the labour market remains tight; all factors behind what many feel is a challenging near-term economic future for the UK. Remembering the inherently forward-looking nature of financial markets, asset prices have adjusted, downwards unfortunately, to reflect this fact. Provided further nasty inflation-related surprises are not lying in wait, stabilisation of interest rates should see volatility of asset prices decline and markets reframe valuations back in-line with underlying fundamentals, rather than shorter-term expectations of macroeconomic data points.

Progressing further through the year, debt, deals and discounts are three discussion points remaining. The cost of debt and refinancing cycles are expected to have meaningful impacts on corporate profitability and household discretionary spending budgets. Acquisitions are starting to come through in pockets of the UK financial markets on the back of optically attractive valuations; more could be on the cards. Discounts within the investment trust sector reached their widest levels since the financial crisis in April, remaining wide and raising questions around potential bargains on offer.
 
Amidst the market gyrations of the last eighteen months and subsequent declines in investor confidence, the investment trust sector has seen share price discounts to Net Asset Values (NAV) widen to levels last seen in the financial crisis. At the end of June, the Association of Investment Companies (AIC) reported a weighted average discount of nearly 14% across all UK-listed investment trusts. Some sectors have felt the pain greater than others, most notably Real Estate Investment Trusts (REITs) and Private Equity, where discounts around the 35% mark have become common place. For bargain hunters, the sector looks to be showing opportunities provided comfort can be achieved in the future pathway of reported NAVs. As share prices track these releases, greater resilience in the reported figures over time could see share prices revalue and returns enhanced by discounts narrowing.
 
The effect of discounts is not limited to the investment trust sector. Listening to UK equity fund managers mention the valuation discount of UK equities to their US counterparts has been a common theme in recent years, with seemingly similar companies holding markedly different valuations based on their country of listing. So wide have these discounts become in both listed equities and listed investment companies, that merger and acquisition activity is becoming apparent and could potentially become a more common theme going forward. In the REIT sector, activity has been notable, with the takeovers of the likes of Civitas Social Housing, Industrials REIT and CT Property Trust all at healthy premiums to prevailing share prices. Yet to feed into the listed equity space, mergers and acquisitions could become a common headline, as pointed out by one of the leading UK smaller companies fund managers recently, highlighting listed companies trading at a discount to recent valuation multiples seen in private market deals.
 
With interest rates influencing the cost of debt, headlines have focused on personal debt, mainly in the form of mortgage rates. On a corporate level, rising debt costs have a very real impact, as we see in multiple segments of our Summer issue of 1875. With many companies relying on the corporate bond market, coupons on new bond issues are markedly higher than in the zero-interest rate world, sparking concerns around debt refinancing and potential defaults in the lower quality tiers of the high-yield markets. We will take a high-level look at this technical topic through our Summer issue of 1875 and see if there are grounds for concern.
 
Finally, we take a look at another area capturing news headlines for all of the wrong reasons: regulated water utilities. Thames Water, the utility company serving most of London and much of the South East, came under the spotlight for multiple issues from poor operational performance to a debt-laden balance sheet and ballooning interest bill on the back of the structure of its debt. In a sector where the disparity between the top and bottom performers is significant, we take a look at Severn Trent, one of three listed names in the sector and a payer of one of the few inflation-linked dividends in the FTSE 100.

This article was taken from the Summer 2023 issue of 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

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. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
 
Debt, Deals and Discounts

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