Investing in infrastructure in the current environment
Rising US interest rates, as a result of better economic conditions and an uptick in inflation, are causing concern, chiefly for valuations in stocks labelled ‘bond proxies’ – securities with valuations that apparently benefitted disproportionately from the very low interest rate environment in the US.
With long-term government borrowing rates used as a proxy for the ‘risk free rate’ (the building block of the common discounted cash flow valuation models used by financial analysts), if rates are rising, all else being equal, analyst valuations of securities will fall. Similarly, rising inflation generally increases input costs, pressuring profits and reducing values by reducing cash flow.
One of the so-called bond proxy sectors of interest to us is infrastructure – long duration, monopoly-like assets charging some variant of a usage fee essential for the smooth functioning of society.
Infrastructure asset valuations are cash flow-based, and on the face of it, sensitive to interest rate movements.
Indeed, for some regulated utilities such as those providing some essential basic need; volumes and therefore charges are often not influenced by swings in the broader economy. These assets do tend to behave in a more bond-like fashion, but how exactly they do so depend on the underlying regulatory rules.
In contrast, assets such as toll roads and airports (where cashflows are generated by patronage or usage) tend to have increasing revenues and margins in a rising interest rate and inflation environment. Inflation and interest rates tend to rise as a result of growing economies and growth tends to increase the usage of these assets, thereby adding to revenue.
In these assets in these circumstances, revenues can rise more quickly than capital costs and expenditure, increasing margins. Furthermore, some of these assets charge usage rates that are explicitly linked to inflation. In contrast, in falling growth scenarios, patronage can fall with the consequent negative effect on revenue.
So, what about the increase in debt financing costs?
Infrastructure assets by their nature (long-term stable cash flows) can raise high levels of cheap debt financing. In general, these companies have used the very low interest rate environment and tended to finance long term and fix their interest rates, thus reducing this risk. In addition, for regulated utilities, many have the ability to pass changes in debt financing costs through to their usage charges.
We continue to believe in the merit of holding an allocation towards infrastructure assets within a diversified investment portfolio. A balanced portfolio of carefully selected infrastructure assets can perform well in a rising interest rate and inflationary environment. Inflation-linked revenues, good operating margins and well-managed gearing levels can give them strong reliable cashflows.
It’s important to note that as interest rates rise, there can be a period of stock price underperformance
This is particularly the case when interest rates rise as the result of positive surprises in economic growth with inflation lagging or remaining relatively static (that is, real interest rates rise). However, as the underlying revenues respond to growth and inflation, and as cash flows show consequent growth, value tends to rebound. Accordingly, periods of underperformance may be appropriate times to add to positions in the space.
This insight may contain general financial advice and was prepared without taking into account your objectives, financial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Any forward-looking statements are based on current expectations at the time of writing. No assurance can be given that such expectations will prove to be correct.