Thread by @leading_nowhere

I've been interested in power transmission INVITs since the first came out with an IPO in 2017, India Grid Trust. Powergrid INVIT is another that debuted recently.

A thread on how to compare the two 👇 (1/18)

@GhanishtNagpal and I analyzed India Grid Trust from the DRHP stage. There was a lot to like - AAA credit rating, robust underlying assets with 35 year contract terms and payments guaranteed by Powergrid as the Central Transmission Utility. (2/18)

Operators also have perpetual right of way for the particular route of the transmission line. Which means when the contract expires, the government can't replace you as the operator. It either renews, or, if the operator is replaced, get another transmission line laid. (3/18)

Transmission operators choose the most efficient route for laying the transmission lines. Anyone looking to replace the operator after contract expiry will need to set up its own lines on less efficient routes and more expenditure. Perpetual right of way matters. (4/18)

Another feature of transmission contracts is fixed and variable tariffs. Tariff generally starts high and drops off a cliff after a few years, to allow the operator recover fixed costs early. This is important, because the yield today will not be the yield tomorrow. (5/18)

When we looked at and invested in India Grid Trust, the primary question on our mind was - how will the yield sustain? If the yield does not sustain, there will be significant capital erosion. In the early days, everyone had doubts on India Grid Trust. (6/18)

India Grid Trust, by our good fortune, was beaten down by the markets for a long time, allowing entry at yields as high as 15%. We loaded up, there was significant margin of safety, especially when yields were diverging from govt bonds by as high as 700 bps. (7/18)

Comparison with govt bonds should not be lightly made - the safety is unparalleled and no instrument will generally trade at or near the govt bond rate. Very few securities can match that risk profile. AAA rated comes close though, and the underlying assets backed it up. (8/18)

That still left the question of yield sustaining over the long term. India Grid Trust, to their credit, were transparent with tariff structure and drop in tariffs a few years down the line. They had a plan to sustain the yield. (9/18)

4 years down the line, India Grid Trust has made third-party acquisitions to add cash flows for distribution. In fact, India Grid Trust has increased the distribution and guided sustainable yield over a considerable period. (10/18)

So what's the point? When you're buying an asset for yield, you HAVE to look at whether the yield is sustainable. Platitudes from the management on future acquisitions doesn't cut it. Neither do mindless acquisitions, more assets must be added at cash-accretive prices. (11/18)

A look at IRB INVIT Fund, where many acquisitions were promised but none happened. The contracts for a couple of their assets generating significant cashflows will expire in 2 years or so. The market looks ahead and adjusts the price to reflect the expected drop in yield. (12/18)

What about Powergrid INVIT? PSU assets, robust cashflows and 10-11% yield. Sounds great for the investor looking for a high yield instrument for regular income. But there is major uncertainty on the future yield. Even the Powergrid MD knows it (extract from ET interview). (13/18)

It's not like Powergrid won't be transferring more assets to the INVIT. They will be (see screenshot), but as an investor your question must be - will it be with the intention to sustain the yield or to just get the assets off the books of Powergrid? (14/18)

Knowing how PSUs operate - doubtful whether Powergrid will be looking out for investor's interests. Their masters are the government and they will be looking to simply monetize the assets and keep recycling capital. Helping you make 11% per annum is not their objective. (15/18)

In sum and substance, investors should be careful about investing in Powergrid INVIT with the expectation of the current yield. The drop in price will be sharp and precipitous if the market starts valuing the instrument on a lower yield. (16/18)

Example - let's say X gives you 10% yield (INR 10) on a price of INR 100. If the market values the future yields at 8% (INR 8), the price will drop from INR 100 to INR 80 (10% yield). A 20% haircut on your capital, and it's likely permanent unless something changes. (17/18)

This is imperative to keep in mind when investing in yield instruments with variable payouts. Powergrid INVIT may make sense at a lower price, but at the current price the investors are looking at a decent risk of capital erosion.

Over and out. (18/18)

Epilogue: Who does Powergrid INVIT make sense for currently? For large institutions (pension funds, insurance, EPFO, etc) who hold for a long time and are extremely happy with a 8-9% yield. Don't need to worry about capital erosion when you're not looking to sell!