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NESF is in a better position than other funds regarding refinancing of debt because it made a large preference share issue with a fixed dividend of 4.75p per share. This issue is not redeemable, so will not need to be financed.

Unlike the Renewable Energy Funds, HICL has hardly increased its dividend over the past few years, and GCP has no plans to increase its dividend at all. Anyone who buys UKW at the current price is not going to regret it.

Hi Fregatr,

It's the same throughout the sector - look at the yields on FSFL and particularly NESF.

Hi Damianmoore,

Thanks for the link. I think the writing is on the wall for this Trust, although when the inevitable dividend cut occurs is anyone's guess.

I'm thinking of constructing a simple two share model to illustrate how dividend-washing works. Assume each share pays the same annual dividend, but at different dates in the year. Further assume there is no underlying captial growth, so the XD price of each share remains fixed at 100p. Consider a strategy where the fund manager invests in one share which is sold just after the XD date, then re-invests in the other share which is sold just after the XD date, and keeps repeating. This will generate twice as much dividend income as the underlying yield on each share, but number of shares held (and the capital value of the fund) will slowly but steadily decline.

Dear Damienmoore,

I would like to thank you for alerting me to HFEL's damaging dividend-washing strategy. For some time, I had wondered how the fund had a distribution yield significantly higher than the underlying yield on its portfolio, and decieived myself that it was explained by option-writing or leverage. Thanks to you, I sold my shares 287p and saved myself further captital losses. Please continue to post here - you are performing a public service and may discourage unwary investors from buying HFEL shares.

At some point, HFEL will be forced to cut its dividend. The dividend yield on the unit trust equivent of HFEL (Henderson Asian Dividend Income) is already much lower, because a unit trust has no reserves and can only distribute income. I occasionally visit this board for the same reason that a psychologist might be interested in the behaviour of passengers aboad the Titanic. It gives me no pleasure.

The underlying dividend yield on the fund's assets is lower than the dividend yield distributed to the fund's shareholders. This underlying yield has been stated (without comment) in the annual report. The only way of achieving the higher distribution yield is through "dividend-washing" and other strategies that convert capital into income. Thus, the poor capital performance of HFEL compared to other Asian funds, e.g. AAIF.

Hello hghotshot,

This is all true, but there was also an abrupt fall in NAV (of about 2p) in March which I suspect was a loan default. There needs to be more transparency on defaults given that it's the only real risk (apart from inflation).

Hello tichtich,

You raise some important issues that I have been puzzling over.

First, I agree with your understanding of how the unlevered discount rate to used to calculate NAV. As you say, the nominal outstanding debt is deducted from the discounted revenues.

Second, I believe the levered discount rate is that which gives the same NAV as the above when the debt cashlows are projected and discounted. This is higher than the unleveraged discount rate because the company can borrow at a lower rate than 8% per annum. The unleveraged discount rate should be a more accurate estimate of the projected return on ukw shares.

Third, I cannot understanding why the 10% leveraged discount rate only gives a 9% return to the shareholders.

Is the company allowing for higher borrowing costs when it re-finances its existing loans?

Fourth, I agree that the projected real return is more useful than the nominal return. Your 9% minus 2.5% calculation is a slight overestimate because short term inflation rates are assumed to be higher than 2.5%.

Lastly, the calculation above assumes the investor buys the share for its NAV rather than market price. If the market price is lower than NAV, the projected return on buying the share is higher than implied by the leveraged discount rate. I have tried to construct a spreadsheet model that allows for this effect.

Hello tichtich,

Thanks for your comments about the discounted cash-flow method, which we actuaries are compelled to study in the professional exams!

What you said about the calculation being based entirely on the projected cash-flows from existing assets is correct and has important implications. If the DCF calculation predicts an internal rate of return of 9% per annum, it means enough cash is being generated by existing assets to give the shareholders an annual return of 9% plus the return of their capital. So if no new investments were made, the company would accumulate enough cash to make regular capital repayments as well as paying the dividend.

Lastly, although depreciation is not a cash-flow, it is allowed for implicitly in a DCF calculation because the term of the cash-flow stream is reducing over time, hence the DCF value of a wind farm will shrink to zero at the end of its useful life.

Hello dadean,

The depreciation of existing wind farms is offset by the reinvestment of retained profits in new wind farms. This is why UKW believes its NAV per share will grow broadly in line with inflation. On this basis, I would estimate the long-term return on UKW shares as 6% per annum above the rate of inflation (whatever that turns out to be).

Agree tichtich,

Wind energy is now too big a part of energy generation to be replaced. Electricity prices are main source of risk (rather than running costs or even wind resource). Hopefully, the gradual shift to electric cars will be beneficial for the industry.

The point I was making is that similar price falls (over the past 6 weeks) have occured outside the renewables sector, which suggests the cause is not particular to the renewables sector.

Hello Gavster,

Rising material costs are a problem for projects under construction, but UKW invests 99% of its capital in operational wind farms. I am fairly certain that the drop in renewable share prices has little to do with the renewable industry and everything to do with the expected trajectory of interest rates. NCYF and SEQI, which are not renewable energy stocks, have suffered similar falls for this reason.

Scientific American article says wind energy costs are competitive:

https://blogs.scientificamerican.com/plugged-in/wind-energy-is-one-of-the-cheapest-sources-of-electricity-and-its-getting-cheaper/

Hello Monkshood,

You are correct that UKW shares are more risky than gilts and should offer a risk premium. The long gilt yield is currently 4.5% per annum, so if future inflation were 3% per annum, the real gilt yield would be 1.5% per annum. The real yield on UKW shares is currently 6% per annum, implying a risk premium of 4.5% per annum relative to gilts.

As for maintaining UKW's inflation-linked dividend, this has been achieved by re-investing a large share of the profits to grow the assets of the business. High energy prices have produced a temporary windfall, but the valuation model in the accounts assumes that energy prices will fall to more normal levels. Gearing currently gives a 2% per annum uplift to the return on equity, so this margin will reduce (but not disappear) with higher borrowing costs.

Ultimately, it comes down to whether you believe the current risk premium is sufficient. Given the high dividend coverage and growing demand for green energy, it looks sufficient to me.

Hello everyone,

I agree that higher bond yields are probably driving the share price down. However it isn't technically correct to compare the yield from an inflation-linked income stream like UKW with the yield on fixed interest securities.

The appropriate metric to compare the UKW dividend yield with is the expected real bond yield, i.e. the nominal yield minus expected future inflation. If we assume expected future inflation = 4% per annum, UKW is providing a higher yield than all but the most risky bonds.

Hi CheeseKing,

The discount rates used to calculate the NAV on renewable shares are linked to bond yields, so the market may be anticipating falls in NAV. However, NAV has already risen a lot over the past 2 years because of inflation, even though bond yields have risen. Consequently renewable share are now trading at large discounts to NAV which is not something I've seen since I began investing in them in 2018. Best of luck to those who think they can buy at the bottom!

Current dividend yield > 5.8%. Don't think it's ever been this high. If they maintain their commitment to increase the dividend in line with RPI, this implies a real return of 5.8% per annum, which is more than the UK equity market achieved over the 20th century.

Hello Kentio,

Sorry for the delay in replying. SEQI invests in both fixed and floating rate debt. With recent interest rate rises, the interest received on floating rate debt has risen, allowing a 10% increase in the dividend. New investments in fixed rate debt will also be made at higher yields. As these changes have arisen purely from higher interest rates, they will not produce sustained dividend growth in the future, and may be reversed if interest rates fall.

However, SEQI also has a policy of re-investing part of its interest income. It's original stated aim was a 1% per annum increase in net assets per share, and this should result in long-term dividend growth. Currently, it seems to be re-investing income in share buy-backs, which will have a similar long-term impact on net assets per share. This is justified by the large discount in the share price relative to net assets per share. So far, they've bought back about 3% of their share capital, which suggests the growth in net assets per share might be faster than 1% per annum.

What do you think of the 6% increase in the target dividend? Looks pretty weak given the rate of inflation and the previous 2% increase.