In the second article of a two-part series, John Julian, Infrastructure Investment Director, explores the impacts that a rising interest rate environment may have on infrastructure asset valuations.
The impact of rising rates on asset classes is top of mind for investors, with infrastructure being no different. In this article, the second in a two-part series, John Julian, Infrastructure Investment Director, explores the impacts that a rising interest rate environment may have on infrastructure asset valuations.
Quickly recapping from my last article, the reason we are seeing rising rates is that we are seeing improving economic conditions. In this environment, along with rising interest rates, we expect to see increasing economic growth and increasing inflation.
As is the case with the impact of rising interest rates on cashflows, considering the impact of interest rates on asset valuations in isolation is far too simplistic. The impact of rising rates on infrastructure valuations is a complex multi-faceted area, and it is important to consider the overall picture rather than focus on just one element.
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.
Unlisted and listed infrastructure are valued differently, so it makes sense to consider each separately.
Impact on unlisted infrastructure valuations
Unlisted infrastructure assets are valued by independent experts. These valuers typically use a discounted cashflow valuation methodology, which involves discounting the future cashflows of an asset by an appropriate discount rate to arrive at a net present value for the asset. In simple terms, and assuming all else remains the same (when is that ever the case?), if the discount rate decreases then infrastructure asset values go up, and if the discount rate increases then infrastructure asset values go down. In addition, importantly, the independent valuers also consider comparable transactions in arriving at their valuation outcome. This means that the demand for assets is taken into account in their valuations.
The main impact of interest rates on valuations is felt through their impact on the ‘risk-free rate’, which is a component in setting discount rates. Valuers typically use long-term government bond yields as the risk-free rate. It follows that, if no other components making up the discount rate change, an increase in the bond rate will lead to an increase in the discount rate. As noted above, all else remaining the same, an increase in the discount rate would result in a valuation reduction.
However, I believe the independent valuers have already priced the risk of future interest rate rises into their valuations, either by using longer term bond rate averages for the risk-free rate, or by including buffer margins (or risk factors) in their discount rates. Each of these approaches mitigates the risk of future interest rate rises.
Looking backwards, as interest rates fell to their current lows, the discount rates applied by valuers did not track the downward trajectory of government bond rates. So what this says to me is that valuers have, in effect, priced in the risk of future rises in interest rates to more moderate levels, and that current unlisted infrastructure asset valuations have significant buffers built in against bond rate increases. I expect valuers will unwind these buffers in the face of increases in interest rates, which should mean that current discount rates, and hence asset valuations, will not be greatly impacted by the expected moderate interest rate increases over the next few years.
In addition to the discount rate, another critical input into valuations is cashflows. As mentioned above, in a rising interest rate environment, we also expect to see improving economic growth and increasing inflation. The cashflows of many infrastructure assets are leveraged to global growth (e.g. airports) or inflation (e.g. toll roads) and will benefit from increasing cashflows in a higher growth/higher inflation environment. Increasing cashflows will have a positive influence on valuations.
This opinion seems to be shared by many institutional investors in the unlisted infrastructure market. Demand for unlisted infrastructure assets globally is still strong, with many investors underweight in their portfolio allocations to infrastructure and looking to allocate additional capital to the asset class. This strong appetite for infrastructure should also help to support valuations.
Taken together, I believe that these factors mean that unlisted infrastructure valuations should demonstrate a high degree of resilience in the face of moderate rises in interest rates.
Impact on listed infrastructure valuations
Listed infrastructure market capitalisations and unlisted infrastructure asset valuations are quite different, with a key difference being that listed infrastructure pricing is impacted by listed market sentiment.
We saw this following the announcement by the US Federal Reserve earlier this year regarding their expectations of a series of cash rate hikes in 2018. This led to a significant correction of listed infrastructure prices. Consequently, in my opinion, listed markets have now largely factored in rising interest rate impacts.
Generally speaking, listed infrastructure companies’ balance sheets are in good condition, with dividends supported by stable cashflows which are growing at healthy rates.
We expect listed infrastructure companies will deliver good operating results during the course of the upcoming year, and that this will lead to a recovery in pricing – though it wouldn’t surprise me if we see further volatility at various points along the way.
The impact of rising interest rates on infrastructure will vary having regard to specific characteristics of individual assets. This being the case, I think that 2018 will demonstrate the value of a well-diversified infrastructure portfolio.
I don’t expect that a moderate increase in interest rates will have a major impact on infrastructure asset cashflows, as mentioned previously.
On the valuation front I think that strong demand for unlisted infrastructure assets, strength in growth-linked asset cashflows, together with the inbuilt valuation buffers will be supportive for unlisted infrastructure valuations. While I think we will see further volatility at various points, I expect the operating performance of most listed infrastructure companies to remain robust, and that this will be recognised by the market leading to a recovery in share prices.
Consequently, a well-constructed and well-diversified infrastructure portfolio should be resilient in the event of the anticipated moderate bond rate increases.
Missed the first article?
In the first article, John Julian explored the impact that rising interest rates will have on infrastructure asset cashflows. Read more
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