SMALL-CAPITAL IDEA: Falling interest rates drive renewable infrastructure

Last month, the Bank of England provided borrowers with much-needed relief by cutting the base rate for the first time since March 2020, reducing it to 5% from 5.25%, its highest level in 16 years.

Given the latest inflation data, which turned out to be lower than expected, the chances of a second interest rate cut in September are decreasing.

For private investors, this could mean a new boost for the stock market, as lower interest rates make bonds and savings accounts a little less attractive. But while a rising tide lifts all boats, some stocks are poised for smoother sailing than others.

One sector that could particularly benefit from changing interest rates is renewable infrastructure investment funds.

Historically, the value of these funds has increased as interest rates have fallen.

According to research commissioned by Foresight Group, the company that manages the Foresight Solar Fund (FSFL), this trend has been going on for at least a decade.

“This inverse relationship appears to hold true across all listed renewable energy sources, but the correlation is particularly strong for mutual funds,” says Ross Driver of Foresight Solar.

For those following the green revolution, this is promising news. In fact, it is one of several positive aspects that could rekindle interest in the sector.

The Labour government, backed by a large majority in Parliament, looks set to support the renewable energy industry, with investors breathing a sigh of relief at the prospect of political stability.

The government’s revised budget for this year’s Contracts for Difference (CfD) auction and proposed changes to the planning system suggest the wind is finally blowing in the right direction.

Optimism is fueled by the fact that electricity price forecasts are trending upwards, creating the potential for higher revenues and improved cash flow for renewable energy projects.

Following the turbulent period following Russia’s invasion of Ukraine, European countries have redoubled their efforts to achieve energy independence, resulting in more favourable prospects for long-term planning in the renewable energy sector.

This renewed optimism is a welcome change after a difficult period of macroeconomic headwinds.

The high inflation that has followed the pandemic has prompted central banks around the world, including the Bank of England, to raise interest rates.

In particular, the BoE has raised its policy rate 14 times since December 2021. This aggressive fiscal tightening, the most intense in four decades, has hurt investor interest in renewable energy investment funds, effectively closing equity markets to new issuance and stifling growth in these instruments.

“The transition to a low-carbon economy is one of the greatest investment opportunities of our generation. The window of opportunity is opening again,” says Foresight’s Driver.

“I don’t think everything will go smoothly now, there will definitely be some obstacles, but the overall direction of travel is now more positive.”

Against this backdrop, investment funds investing in renewable infrastructure appear attractive due to the current discount at which their shares trade relative to the net asset value (NAV) of the companies.

That discount could be as much as 40 percent. As capital flows back into stock markets, you’d expect that gap to narrow and stock prices to benefit from the uptick—though, as Driver points out, it’s unlikely to be a straight line of progress.

For those looking for both income and growth, the Foresight Solar Fund is worth a closer look. At current prices, it offers a projected dividend yield of 8.5 percent.

Another standout fund is the NextEnergy Solar Fund, which is forecasting a high return of 10 per cent, making it one of the largest contributors to the FTSE 350.

What’s more, NextEnergy recently got the green light to launch a £20m share buyback programme, further increasing its appeal.

But the list doesn’t end there. Others worth considering include Bluefield Solar, UK Wind, The Renewables Infrastructure Group (TRIG) and John Laing Environmental Assets (JLEN).

When selecting my ISA account, all six funds performed well across key criteria: they are asset-backed, offer income and have growth potential.

Of course, it should be remembered that none of these investments guarantee success.

While current risk levels may not seem particularly daunting, renewable energy investment funds are not without risk.

However, with a combination of political support, improving market conditions and attractive valuations, they could represent an interesting opportunity for those looking to invest in the green energy transition.