There has been much speculation around the Reserve Bank of Australia’s (‘RBA’) intentions to raise rates over the next few years. AMP Capital’s Investment Strategy and Economics team recently forecast that, whilst rates will likely remain on hold over 2017, the RBA should respond to improving market conditions with a series of moderate rate hikes, with Australian 10-year government bond rates edging up from 2.7% (as at March 2017) to approximately 4% in three years.
How will infrastructure assets perform in a rising rate environment, and to what extent will unlisted infrastructure valuations be impacted?
In isolation, rising bond rates tend to have a negative impact on unlisted infrastructure asset valuations through higher valuation discount rates and increased debt servicing costs. However, a recent paper published by AMP Capital’s Direct Infrastructure team explains that rising rates are only one part of a much bigger story.
Different types of unlisted infrastructure assets exhibit varying degrees of resilience to bond rate increases.
- Infrastructure growth asset valuations can still grow strongly in the face of moderate bond rate increases because if cash flows are leveraged to economic growth, these assets are likely to see stronger net cash flows in the higher bond rate environment. Of even greater importance are the buffers built into current unlisted valuations. Valuers were reluctant to pass through the full impact of falling bond rates when bond rates fell, by increasing risk margins in their valuations. As bond rates increase, we expect valuers to unwind the high risk margins. Consequently, unlisted valuations are expected to be resilient in the moderate rising rate environment, anticipated in AMP Capital’s house view.
- Larger increases in bond rates could restrict valuation growth if the valuation buffers are completely drawn down, although total returns are likely to remain positive, in scenarios where government bond rates are constrained to less than 7%.
- Bond-proxy PPP concession assets also have significant valuation buffers and cash flow hedges which should allow them to outperform traditional bonds in a rising rate environment, while still delivering strong yields, under moderate bond rate increases;
- Regulated utility valuations will largely remain indifferent to bond rate movements, as the impact of rate increases will pass through to consumers.
When considering the overall attractiveness of the asset type, unlisted infrastructure valuations are largely immune to listed market sentiment and are far less volatile than listed market caps. Consequently, they have can bring valuable levels of defensiveness for investors’ portfolios.
The key point?
Although there may be some short-term volatility in response to a rate rise, unlisted infrastructure assets are well-positioned for the long-term. For a full version of this paper, please click here