Alex Stephen looks at how infrastructure investment can be beneficial during a rising interest rate environment.
The recent moves by the US Federal Reserve (Fed) to increase interest rates by 0.25 per cent in both December and March would have been noted by investors considering an allocation to listed infrastructure.
After all, listed infrastructure companies are viewed as being highly sensitive to interest rate rises and have performed well in the last decade over which time interest rates have fallen significantly globally.
So why is it important? Firstly, infrastructure companies tend to be able to carry more debt than other companies due to the relatively sustainable and secure nature of their cash flows. At the end of December 2016, the weighted average of total debt to total assets for the global share market was 23.5 per cent compared to 42 per cent for the infrastructure sector.
This raises the concern that with their higher level of debt, infrastructure companies will have more sensitivity to increases in interest rates as their earnings will be negatively impacted. And secondly, if interest rates rise, bonds and cash will become much more appealing and investors will move away from the currently strong yields of equities and especially infrastructure companies, in turn impacting the companies’ share prices.
An interest rate jump is unlikely
If interest rates were to rise quickly, being overexposed to debt would no doubt impact many companies’ returns, however we are currently very near the bottom of the interest rate cycle.
As charts 1, 2, 3 and 4 show, there has been little appetite for interest rate increases in the US or any other developed market. In fact, the major economies of Japan and Europe are still operating funding programs to provide liquidity to their markets – Australia and New Zealand have recently just cut interest rates and the UK’s gradual recovery has been knocked by the vote to leave the European Union.
Inflation remains stubbornly low across the world and it is hard to see this as a landscape for rapidly rising interest rates. We believe it is unlikely for central banks to significantly increase interest rates until there is a pickup in inflation. Therefore interest rates aren’t likely to run far ahead of inflation and we believe they should remain relatively stable.
Bonds and cash yields remain low
If investors are seeking an inflation-beating level of yield, traditional investments like bonds and cash may not be the answer for the near-term. Yields on treasury bonds are extremely low and in some cases negative (Switzerland, Germany and Japan) and it will take several years of sustained increases in treasury bond rates across the world to make these investments look appealing again. To achieve inflation-beating returns in fixed income and cash, investors need to go up the bond risk curve and accept far lower quality investments.
Equities can look appealing in this scenario despite the potential volatility, and investments in more defensive sectors, like infrastructure, look even more appealing. Relative to listed global equities and property, the infrastructure sector offers relatively stable cash flows, solid dividends alongside lower volatility and diversified returns, making a sound investment case.
Charts 5 and 6 show firstly how the yields from infrastructure companies have been consistently higher than global equities, and secondly how much extra yield they have generated when compared to the local market cash.
Chart 6 also shows the period of strong share price growth leading up to the global financial crisis (GFC) resulted in relatively low dividend yields. Dividend yields change significantly through time because they’re driven not only by dividends, which may be relatively stable, but also share prices, which are tied to market conditions.
Infrastructure as a hedge against inflation
Importantly, certain infrastructure companies can offer protection against increases in inflation. A sizeable portion of Redpoint’s portfolio is invested in regulated utilities. These companies are able to shield investors from rising inflation by passing through higher interest rate costs to their end consumers through inflation linked price increases. Regulators understand the needs of these companies to continually reinvest in their operations. The essential services they supply include electricity, water, gas, and waste disposal.
Utility companies also tend to have very long-term debt agreements, and the better managed companies have been taking advantage of the low rate environment by reducing the rates of their long-term debt facilities by locking in lower rates for longer.
A case for global infrastructure
While investing in infrastructure is usually associated with government spending or private equity companies, astute Australian investors have also benefited from the asset class by accessing quality listed infrastructure companies.
However, while Australia is home to a few of these companies there are simply not enough of them and there is too little variety to make it an attractive stand-alone investment. There are currently 153 companies in the FTSE Developed Core Infrastructure Index of which only eight are Australian companies.
By expanding the universe to include all developed markets the investment characteristics of global infrastructure are far more appealing both in the context of diversification benefits and in delivering less volatile retirement income streams.
Interestingly, listed infrastructure is a relatively small subset of global equities, yet these companies are still a highly investible universe with $2.2 trillion of market capitalisation. This is considerably larger than the Australian listed equity market at $1.5 trillion.
Also, the benefits usually associated with infrastructure assets, namely a stable and growing dividend stream, and lower volatility, means the asset class is particularly suited to a wealth preservation-focused, ageing demographic moving from accumulation to retirement.
Investors can choose direct investment or through the listed equity market. There are significant benefits of investing through the listed market, namely: daily liquidity, daily valuations, no drawdown or lock-up periods and increased diversification.
While investors in listed markets are likely to experience more short-term price volatility, (due to the daily mark to market of listed securities versus unlisted), long-term returns will be driven by the nature of the underlying assets.
Investors are right to be cautious of a rising interest rate environment. But that shouldn’t be all they take into account. Investors should consider their investment objectives and portfolio strategy in light of a slowly rising interest rate environment.
We believe in such an environment, well-managed infrastructure companies will continue to offer investors inflation-linked income that’s higher than most other asset classes, lower volatility than broader global equities, and the potential for capital growth.
Alex Stephen is senior portfolio manager at Redpoint Investment Management.