One of the things I enjoy about my job is having the opportunity to regularly get out of the office to talk to investors and hear what’s on their minds. Recently I enjoyed having the opportunity to speak at the 2018 Combined Community Trusts conference in Hamilton, and talk to a number of investors about infrastructure investing. A key topic of interest that comes up in most meetings, is the impact of a rising interest rate environment on infrastructure assets. It’s also the subject of an Insights paper I recently co-authored, so here are my thoughts on what higher interest rates mean for the infrastructure asset class.
The reason we have 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. But hand-in-hand with the increase in economic growth we expect to see increasing interest rates and inflation.
If you think about increasing interest rates in isolation, a common initial reaction is that this is bad for infrastructure. However, this is too simplistic – in practice the situation is much more complex.
Interest rates impact infrastructure in two main areas. They impact the cash flows the assets generate, and they impact valuations.
When considering impacts on cash flows, 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 have a sensible level of debt in their capital structure. Increased interest rates may impact cash flows through an increased interest cost on that debt.
On the face of it this sounds negative, but infrastructure companies are 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. Many infrastructure companies also use derivatives to hedge their base interest rate exposure.
When interest rates rise, it tends to indicate economic growth is improving. Therefore, assets that benefit from a higher growth environment can increase their revenues as GDP growth increases, which can help mitigate the impact of a rising interest rate cycle. 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 duty free shopping, leading to higher revenues for the asset.
Yield-focused assets are less likely to be able to drive additional revenues in this environment, though the impact of rising rates on their cash flows may still be lessened by a range of factors. For example, many of them have inflation-linked revenues – so their operating cash flows will benefit from higher inflation, while regulated utilities can typically pass interest rate costs through to their end users.
On the valuation front, unlisted infrastructure assets are valued by independent experts who typically use a discounted cashflow valuation methodology. One of the inputs into this methodology is the risk-free rate, which is usually represented by the long-term government bond yield. 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 impacting asset valuations.
Another critical input into valuations is cash flows. The cash flows of many infrastructure assets are leveraged to global growth (eg airports) or inflation (eg toll roads) and will benefit from increasing cash flows in a higher growth/inflation environment. Increasing cash flows will have a positive influence on valuations.
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.
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, which led to a significant correction of listed infrastructure prices. Consequently, in my opinion, listed markets have now largely factored in rising interest rate impacts.
The impact of rising interest rates on infrastructure will vary having regard to the specific characteristics of individual assets. This being the case, I think that 2018 will demonstrate the value of a well-diversified infrastructure portfolio. A moderate increase in interest rates is not expected to have a major impact on infrastructure asset cash flows. On the valuation front, strong demand for unlisted infrastructure assets, strength in growth-linked asset cash flows, together with the inbuilt valuation buffers will be supportive for unlisted infrastructure valuations. While we may see some volatility in listed markets, we expect the operating performance of most listed infrastructure companies to remain robust. Consequently, a well-constructed and diversified infrastructure portfolio should be resilient in the event of the anticipated moderate bond rate increases.
Further information can be found in the Insights paper ‘The impact of rising interest rates on infrastructure’.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.