The impact of rising rates on asset classes is top of mind for investors, with infrastructure being no different. In the first of a two-part series, John Julian, Infrastructure Investment Director, explores the impacts that a rising interest rate environment may have and why.
One of the things I most enjoy about my job is having the opportunity to regularly get out of the office and talk to investors and financial advisers, and hear what’s on their minds. Unsurprisingly, in pretty much every meeting at the moment, the first topic that comes up is the rising interest rate environment and what this means for infrastructure.
The good news is that the reason that we in a rising interest rate environment is that economic growth is picking up in a number of countries around the world. This is great news for investors.
Of course, things are different all around the world, and countries like the US, Canada and Australia are leading the recovery, while places like Europe and Japan are more subdued.
Hand-in-hand with the increase in economic growth we expect to see increasing interest rates and inflation.
Interest rate rises are being led by the US Federal Reserve, with expectations that we will likely see 4 incremental rate rises this year. Things are not moving quite so fast in Australia, though we think it’s likely that the Reserve Bank of Australia will increase the local cash rate at the start of next year.
While we are expecting increasing levels of economic growth and interest rates, we are not expecting to see them hit the heights we have seen in the past any time soon.
If you think about increasing interest rates in isolation (and assume everything else remains the same) a common initial reaction is that this is bad for infrastructure. However, looking at the impact of interest rates in isolation is far too simplistic – the situation is much more complex and multi-faceted. In addition, there are many different types of infrastructure assets, and the impact of a higher growth and interest rate environment can vary significantly depending on the specific characteristics of individual assets.
Interest rates impact infrastructure in 2 main areas. They impact the cashflows the assets generate, and they impact valuations. In this article I will look at the impact on cashflows. I’ll have a look at the impact on valuations in a second article which I’ll write on this topic in coming weeks. In terms of the impact of increasing interest rates on asset cashflows, there are both positive and negative impacts.
Shifts in the cost of debt
When looking at the impact of increasing interest rates on infrastructure asset cashflows, an obvious place to start is with the impact on borrowings. The stable and predictable revenues that many infrastructure assets generate mean that they are well positioned to employ a sensible level of debt in their capital structure. Increased interest rates may impact cashflows through an increased interest cost on that debt.
This sounds negative right? On the face of it, yes it is, though there’s nothing new here. Infrastructure companies are very well practiced in managing the impact of movements in interest rates on their financing arrangements. They typically maintain well-diversified debt portfolios with a range of staggered maturities to help manage refinancing and interest rate risk.
Furthermore, most infrastructure companies use derivatives to hedge their base interest rate exposure. Some assets, depending on the asset type, have the base interest rate on their debt hedged for the full asset life. For example, one of the assets we manage is a social infrastructure asset in the education sector. It has a concession term of 30 years, with 21 years left to run. We have the base interest rate on that asset’s debt hedged for the full term of the concession – so it is not subject to any base rate risk whatsoever.
Infrastructure companies do tend to be exposed to movements in the margin charged by banks over the base interest rate, however this risk only actually manifests itself at the point when you are refinancing debt, and staggering debt maturity across multiple debt tranches helps to mitigate this risk.
In addition, infrastructure companies actively manage their debt books. They don’t sit on their hands and wait around until debt is about to mature before thinking about refinancing it. Instead they proactively look for opportunities throughout the term of the debt to opportunistically refinance when it makes sense to do so. They also typically consider a range of alternative funding sources to obtain the best possible pricing.
Also important to factor into the overall picture, is that we are not just seeing increasing interest rates, we are also seeing increasing levels of economic growth and inflation.
Increased economic growth and inflation
Infrastructure assets that are leveraged to economic conditions (such as airports, sea ports and communications assets) are likely to do well in a higher growth economy. When economies are growing these assets tend to perform more strongly, as they can generally drive additional revenues due to the higher levels of economic activity. Examples might include an increase in the level of freight movements through a sea port, an increase in the number of passengers using an airport, or an increase in the number of trucks using a tollroad.
These additional revenues will be positive for the asset.
Due to their nature, yield focused assets (such as regulated utilities, and government concessions such as public private partnerships or “PPPs”) are less likely to be able to drive higher revenues in a higher growth environment. Notwithstanding that however, the impact of rising rates on their cashflows may still be mitigated by a range of factors, including that many of them have inflation-linked revenues – so their operating cashflows will benefit from higher inflation. Regulated utilities can typically pass through interest rate costs to their end users (although there may be some timing lag). Assets like PPPs may benefit from higher interest income from large cash balances that they are often required to maintain to meet mandated Debt Service Cover Ratios under their financing arrangements.
I hope that the above shows that, when considering the impact of rising interest rate on infrastructure asset cashflows, it is important to consider the overall picture, rather than focus on just one element in isolation. I will look at the impact of rising interest rates on valuations in the next note.
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