Infrastructure

Interest rates and infrastructure: what’s the connection?

By AMP Capital

The infrastructure asset class has become increasingly popular for SMSFs seeking stable income and capital appreciation in a low-growth, low interest rate environment. With interest rate movements on the horizon, John Julian, Infrastructure Investment Director, explains the connection between interest rates and infrastructure.

Infrastructure as an asset class has landed on self-managed super fund (SMSF) investors’ radars recently as they have increasingly sought stable income and capital appreciation in a low-growth, low interest rate environment.

In fact, Australia was one of the first countries to attract institutional investors to infrastructure assets, and more recently opportunities have emerged for retail investors to gain exposure to this asset class.

When assessing an asset class, it’s important to understand how different variables impact returns. For infrastructure, a movement in interest rates is an important variable to consider.

In a rising interest rate world, all things being equal, it might be assumed that an unlisted infrastructure asset’s discount rate will rise, which would reduce the asset’s value. However, there are many other variables in this situation that can impact an asset’s value.

John Julian, Investment Director of AMP Capital’s Core Infrastructure Fund, explains.

“Many unlisted infrastructure assets have been valued based on a long term average of interest rates, which is much higher than current rates. This gives infrastructure assets a natural buffer from increasing interest rates because their valuations have already incorporated a higher interest rate than currently observed. This will help preserve asset values,” he says.

It’s also important to understand that infrastructure as an asset class has many different types of investments, which respond differently to the interest rate cycle.

Some types of assets, for instance can actually derive some benefits in a rising interest rate environment.

“When interest rates rise, it tends to indicate economic growth is improving. Therefore, assets that have revenues linked to economic growth can increase their income as GDP growth increases, which can also protect against any dampening effect of a rising interest rate cycle,” says Julian.

An airport is a good example. It is likely air traffic will increase, driven by increased economic growth, and that there will be higher demand for the associated services the airport provides, such as catering and shopping, leading to higher income for the asset. Therefore, as interest rates and GDP growth rises, so too will the asset’s ability to generate income.

Other examples of infrastructure assets that benefit from economic growth include sea ports and certain toll roads, which benefit from increased usage due to improved economic conditions.

Furthermore, as inflation and interest rates tend to be positively correlated, those infrastructure assets which earn revenues that are linked to inflation, will benefit from the increase in inflation in an environment where interest rates are rising.

“One of our assets is Powerco, the second-largest gas and largest electricity distributor in New Zealand, which is regulated.”

“The regulator sets a regulated return, otherwise known as a cost of capital, which reflects a number of factors including interest rates, broader market returns and prevailing debt margins. As interest rates are included in the cost of capital build-up this adds an element of protection to our return through the interest rate cycle,” he adds.

Sensible leverage

Infrastructure received criticism after the financial crisis as some assets had carried too much debt and underperformed through the crisis.

This is an issue the infrastructure sector has worked through and these days most assets carry a more conservative and sustainable level of debt.

“Post-GFC gearing has been much more conservative. The rating agencies are also much more conservative in their assessment of capital structures,” Julian notes.

AMP Capital’s Core Infrastructure Fund gives SMSF investors access to assets like Melbourne Airport, Powerco, and Sydney’s M5 toll road, assets few retail investors have been able to access in the past.

It includes both unlisted and listed assets, to help reduce volatility but ensure it has a certain amount of liquidity. It has performed well through market cycles in the past, although past performance is not an indicator of future performance.

“It has been popular with SMSF investors who want access to an asset that isn’t highly correlated to equities and that generates sustainable income,” Julian adds.

While any allocation to infrastructure should only form part of a long-term investment strategy, it’s characteristics mean that this asset class is likely to resonate with the SMSF community.

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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