Two deep discount opportunities for brave-hearted investors

The fallout from the mini-budget continues to ripple through the markets with the spike in the gilt yield sending discount rates sharply higher. At time of writing the UK 10-year government bond was yielding 4.25%, the first time it has been this high for many years, with ‘vulnerable’ risk assets tumbling in response.

Assets are valued by discounting their future predicted cash flows into a net present value. In some cases these income streams can stretch out for many years into the future, so when the risk free rate (gilt yield) and the risk premium over and above this amount that is demanded by investors both increase, it can substantially reduce the market price.

The reason that risk premiums are rising is the huge economic and political uncertainty with high and persistent inflation being exacerbated by the war in Ukraine. Many of the world’s key central banks are responding with aggressive rate hikes, which threaten to drive the world’s economies into a coordinated recession.

UK commercial property

For brave-hearted investors the sell-off has created some potential buying opportunities, with one example being UK commercial property. Discounts across the sector have opened up considerably in the last few months in anticipation of property valuations weakening in the face of higher interest rates.

Another contributory factor is that higher borrowing costs would make any debt used to finance the purchases more expensive, which would be a problem if it’s floating rate or just coming to the end of a fixed-term, hence the reason some investment trusts have been scrambling to agree new fixed rate deals. A recession could also mean more vacancies and bad debts.

Kepler Trust Intelligence say that these fears are not unwarranted and could play out in the months ahead, but some of the discounts are now so wide that there may not be much left to price in. They highlight Balanced Commercial Property (LON: BCPT) as a good example, as the shares are currently available at a near 50% discount to NAV with a yield of almost six percent.

Going for a song

Another potential opportunity is the music royalties trust Hipgnosis Songs (LON: SONG) that has just announced the re-financing of its revolving credit facility and the fixing of interest costs. The broker Investec estimates that the all-in cost of debt will be around 6.25% and says that the 25% structural leverage should have been re-financed a lot earlier.

Despite this criticism they remain constructive on the asset class and point out that fixing the interest rate provides investors with some comfort over the dividend in the short to medium-term. They say that the trust now trades on around a 45% discount to their estimated NAV, which provides an attractive margin of safety and implies a discount rate of about 10.5% that provides a significant buffer versus US long-term Treasury yields.

Since the launch in 2017 Hipgnosis has normally traded at a premium or small discount to NAV, but in early 2022 the rating collapsed, with the management doing very little to address the problem. A lot has gone wrong, yet the quality of the underlying assets and current wide discount has led Investec to issue a buy rating, with the broker saying that the trust could find itself vulnerable to corporate action.