This is the last of three instalments on Risk. Don’t miss our analyses of the changing nature of regulatory and reputational risk.
There’s no two ways about it, interest rate hikes by the US Federal Reserve and other central banks around the world are worrying infrastructure investors, uncertain about how their assets will be affected – even if many argue that regulated or contracted infrastructure is an effective hedge against changing monetary policies.
When we surveyed 60 of the 450 institutional investors that attended Infrastructure Investor’s Global Summit in Berlin, their top concern about the asset class was the impact of rising interest rates, comfortably ahead of their second greatest worry: a frothy market. Given recent rate movements, that fear is likely to still be front of mind.
In June, the Fed announced its seventh interest rate hike since 2015, this time bumping borrowing levels to a range between 1.75 percent and 2 percent. The central bank also said in a statement there would be “further gradual increases” if economic activity remained strong and signalled two more rate hikes this year are possible.
Other markets have followed the Fed’s recent moves, hoping to avoid widening interest rate gaps. In Asia, Indonesia’s central bank raised interest rates to 4.75 percent in May, while the Philippines central bank announced its own quarter-point hike. In June, the Reserve Bank of India increased rates for the first time since 2014. Only Europe has held strong, with European Central Bank president Mario Draghi indicating there would be no interest-rate hike until next summer, at the earliest.
So, what’s getting everybody so hot and bothered? As usual with infrastructure, it’s complicated.
According to an interest rate study published last November by Brisbane-based fund manager QIC, there is “unease” that infrastructure investments will be undermined by these changes. “Sensitivity of infrastructure cashflows to interest rates is driven by the underlying impacts on debt servicing, as well as revenues,” the report states.
Stable cashflows from providing essential services has allowed infrastructure to take on high levels of debt – from 40 percent up to around 85 percent, depending on an asset’s risk profile. At the same time, according to the report, interest coverage ratios have remained at high levels, reflecting a low cost of debt.
But as Cherian George, head of global infrastructure and project finance for the Americas at Fitch Ratings, points out, there should be unease depending on what type of debt an investor holds.
“If inflation moved up 25, 50, even 100 basis points, that would be moderately positive from a credit standpoint, particularly if they have a significant amount of fixed-rate debt locked in,” he explains. “But in situations where they’ve taken out a lot of variable-rate debt, when you refinance that debt, you’re going to be paying a higher coupon.”
That see-saw movement permeates the entire discussion about the potential impact of rate rises.
“If you think about the concern the entire market has had about low interest rates, it’s that equity valuations are too high,” George starts. “Equity valuations will have to adjust – if interest rates are up, discount rates are up, equity IRR rates are up. Valuations could go down, but even if they drop, they won’t drop as much relative to other investments.”
However, Ryan Sullivan, co-head of Aberdeen Standard Investments’ real assets group, which manages $4 billion in non-UK infrastructure assets, says infrastructure is a broad asset class, so impacts from rising interest rates and inflation will affect sub-sectors differently. “Generally speaking, it’s probably not a great thing, but the devil is in the details,” he says. “You really need to understand the infrastructure asset’s underlying cashflows, how they are derived, and how that’s re-priced in a higher-interest-rate environment.”
Re-pricing is, of course, at the forefront of investors’ minds, and that’s particularly evident in the fixed-income world. Sullivan uses a fixed-income asset with a long-term, 5 percent yield as an example. “It’s like owning a long-duration bond,” he says. “If you have a rising-interest-rate environment, just like a bond, you expect that asset value to go down,” he explains.
The other side of this scenario, Sullivan continues, is that a lot of capital has been raised to invest in infrastructure, meaning cap rates, risk factors and premiums tend to go down.
“If you’ve had a lot of capital coming into the sector, it’s not as direct of a linkage because people continue to have capital to spend and the yield level is still okay for them,” Sullivan explains.
Pretty much everyone we spoke to – from fund managers to analysts – agreed that core infrastructure will fare well amid these changing monetary policies. That’s because when interest rates climb, inflation usually follows. And with revenue linked to inflation, cashflows from transportation and power assets will as well.
“If you’re invested in infrastructure and your revenues are linked to inflation, that will mean you have an inherent hedge,” George explains. Investors have taken notice of core infrastructure’s inflation resiliency, with many wanting exposure to ensure a portion of their portfolio generates steady returns during periods of relative economic uncertainty.
“Major investors in infrastructure – pension funds and insurance companies – are very cautious by nature and are really looking for long-term stability through economic cycles,” George says. “Infrastructure is a good opportunity almost irrespective of cycle.”
Core infrastructure – “demand-based” assets such as toll roads or power plants – could see equity IRRs rise, he explains. “As inflation increases and interest rates go up, revenues consequently rise along with them.”
According to Sullivan, a lot of this has to do with the way contracts for these assets are structured. He says inflation-linked core assets use contracts – off-take or concession agreements – based on index or pricing levels set each year, ensuring revenue falls in line with changes in monetary policy.
“That is the most direct inflation link you’re going to get,” Sullivan explains. “And when most people think about it being a hedge, that’s what they get comfort from.”
Utilities are a third infrastructure investment insulated from the effects of inflation. These assets gained favour among many investors during the Great Recession years because they did not experience as much volatility as other sectors, according to George. “People had to put their money somewhere and realised utilities will still be needed,” he says.
In developed and emerging markets, utilities are regulated assets, with government watchdogs capping the rates they can charge customers. A regulator will factor in the cost of equity and debt when determining a reasonable rate of return, George explains. That creates revenue visibility, which investors like.
“The stabilising factor of infrastructure in a portfolio comes from a set of typically regulated cashflows that will be very stable through time and usually less cyclical,” Anton Pil, managing partner for JPMorgan Asset Management’s global alternatives business, argued in a previous interview.
Things are less clear cut when it comes to core-plus infrastructure – which has been attracting more investments partly due to a limited supply of core assets – since these assets aren’t necessarily inflation-linked or regulated, George points out.
In that sense, inflation and interest rates may create additional risk for some core-plus assets, “but the greater risk is that [core-plus] is not as stable or protected from competition or technology change”, he adds.
Given some of these asset types are newer, time – and how long investors hold them in their balance sheets – will tell how resilient they really are to different economic cycles