Earlier in the week, we wrote about Stifel Funds view on why they believe inflation may fall more quickly than many expect
Yesterday we took a look at their views on 5 fund sectors available in their report. In this final article in the series, we look at the remaining 5 fund sectors:
- Technology Funds
- Biotech Funds
- Growth Capital Funds
- Royalties Funds
- Debt Funds
Technology Funds
The technology sector has been one of the most sensitive to changes in interest rate expectations, given the growth stock characteristics. After interest rates were aggressively cut in the spring of 2020, tech became one of the most in-favour sectors, with some trusts, such as Scottish Mortgage, seeing extremely high gains over the following 18 months (Figure 8). However, the tide turned a year ago, and as discount rate expectations have increased, growth has faltered and valuations have been questioned, with the result being sharp falls in technology shares. For example, Scottish Mortgage saw a share price increase of +36% in the three years to 03/02/23, but a decline of -23% in the past year to 03/02/23. The technology sector’s discount has gradually widened from a small premium over summer 2020 to a discount of 14% at 03/02/23. A “Fed pivot” thanks to weaker inflation would likely propel the sector back into favour – especially with earlier stage, unprofitable growth companies.
Biotech Funds
As with the technology sector, the biotech sector is similarly sensitive to interest rates with many unprofitable companies valued based on discounted future earnings. While the biotech sector has held up better than the technology sector over the rising interest rate environment in 2022, it has still behaved in a similar way, with the sector’s discount widening and then narrowing again in recent weeks. Excluding the larger firms, biotech is generally a non-debt industry; as a result, the sector has at least been immune to worries about rising debt servicing costs as rates have risen.
Growth Capital Funds
A number of growth capital trusts have been hit hard over the past year, as investors have been worried over hits to valuations and availability of further financing for early stage companies in a tighter macroeconomic environment. For example, Seraphim Space traded on a 20% premium after its IPO in July 2021, but sold-off in January 2022 and has continued to de-rate resulting in it trading on a c.50% discount. Chrysalis is on a wide discount too, of around 37% to the latest NAV of 128p at 31/12/22, after a share price fall of -78% over the past year. Should monetary tightening ease, it is likely investors will be more comfortable backing these early-stage high-growth companies again, resulting in discounts narrowing. In addition, some of the private investments in these growth fund portfolios are valued using comparable listed companies; thus, valuations would be helped if listed markets recover
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Royalties Funds
Rising interest rate expectations have caused investors to question the discount rates used in the valuations of the music royalty funds. Discount rates are important in royalties funds as portfolios are valued based on the discounted expected future income generated. As higher discount rates would lead to valuation declines of portfolios, these funds have moved out to trade on wide discounts to allow for some headroom should such a situation occur. We have seen this happen with both Hipgnosis and Round Hill Music, which trade on discounts of around 50% and 38%, respectively. In the past year, both funds had traded as narrow as a 2% discount NAV, prior to the market worrying about discount rates and leverage. If yields move back down, investors may be more comfortable with the current discount rates used to value portfolios, and discounts could narrow back as a result.
Debt Funds
Debt funds significantly de-rated following the “mini-budget” as gilt yields spiked in early October. Higher gilt yields hit the debt sector because the funds that often have portfolio yields of only between 6% and 8% became relatively less attractive as investors could achieve yields of over 4% “risk-free” with gilts. Therefore, funds yielding slightly higher than 4% but with significantly more ‘risk’ needed to correct to offer some additional value relative to gilts. Funds with “sticky” portfolios, i.e., fixed-rate and longduration loans, became under pressure to increase their portfolio yields to become more competitive post the credit market repricing. As gilt yields declined post the October spike, debt funds generally
recovered too and they should continue to benefit should gilt yields continue to decrease, consequently making these funds more attractive on a relative basis, with scope for discounts to narrow, in our view.
