How realistic is it to believe that infrastructure assets are destined to fall in value as interest rates rise? Theory suggests an inverse relationship but this misses an important factor – the natural hedge that some infrastructure
assets have due to their inflation and growth linkages.
Higher inflation putting upward pressure on interest rates
Inflation has accelerated globally in recent months as fiscally-fuelled demand has run into COVID-induced supply constraints. Chart 1 shows this rapid acceleration, with US
CPI inflation now running at 7.5% year-on-year and the aggregate across the advanced economies (excluding the US) up at 4.0%.
Chart 1: US and Advanced Economies CPI
Source: IFM Investors, as at January 2022
Central banks were initially quick to label this inflation as “transitory” and unlikely to impact interest rate settings. But it has proven unexpectedly persistent. The emergence of the Omicron variant in late 2021 and the reinstatement
of lockdowns in some countries have further complicated the supply chain picture. In response, markets have shifted their interest rate expectations. It is now possible that the US Federal Reserve will start to raise interest rates as early
as March 2022.
Higher interest rates have traditionally been viewed as negative for long duration investments, like infrastructure, as they put downward pressure on asset valuations. This occurs not only because of the potential increase in the cost of borrowed
capital, but because the equity discount rate that is used to value infrastructure assets moves in response to changes in the market risk-free interest rate (i.e. government bond yield). Whilst this is true, we believe the positive linkages
that some infrastructure assets have to inflation and economic growth can provide a natural hedge that may be sufficient to offset these negative valuation impacts.
So how does this natural hedge work?
The natural hedge explained
Two of the key revenue characteristics that IFM targets when investing in infrastructure assets are inflation protection and exposure to economic growth1:
- Inflation protection usually comes in the form of contracted increases in pricing that are linked to the prevailing rate of inflation. This is often a feature of regulated utilities (like water and power companies) and toll roads, and
it normally means that revenues continue to rise as inflation accelerates.
- Exposure to economic growth means that an infrastructure asset’s volumes, and thus revenues, tend to increase with the size of an economy. For example, toll roads have a variety of linkages to economic variables, with many road
concessions benefiting from both rising economic activity lifting traffic volumes as well as toll escalation (often linked to inflation). Value can also be created by reinvesting capital into investments which grow with their customer
Infrastructure’s natural hedge against interest rate rises occurs because inflation and/or above trend economic growth tend to be pre-cursors to, or coincide with, increased interest rates, providing mitigants to the effects of rate increases.
Appropriate capital structures are important
Appropriate capital structures can also help insulate infrastructure assets from the full impact of rising rates. When interest rates are low (as they have largely been for a decade), asset
owners have the ability to refinance debt and lock in the cost of long term financing at attractive rates. Some examples of such measures that IFM has utilised in the past include:
- lengthening loan and/or bond tenors and laddering debt maturities to mitigate refinancing risk;
- combining fixed-rate debt with floating-rate debt, and implementing interest rate swap strategies to lock in historically low rates and largely eliminate floating rate exposures; and
- using our market presence to access highly competitive debt margins.
In a previous paper on this topic2, we found that due to the long duration of underlying debt books where there is minimal exposure to floating rates, the positive effect on portfolio performance from rising inflation was significantly
greater than the adverse effects of rising interest rates on the cost of debt.
Discount rates on the move
It is also important to consider the implication of rising rates on discount rates. Infrastructure valuations rely upon a well-established valuation framework using expert independent valuers who choose a
number of methods to determine the appropriate risk free rate in their equity discount rate calculations. Our experience over decades suggests that discount rates are smoothed by valuers through a number of methods, recognising the long-term
nature of infrastructure assets. We observe that the normalised risk free rate remains relatively stable despite volatility in government bond yields, and expect a more gradual rise in discount rates than what might be seen in central
bank policy rates and long term sovereign bond yields in response to inflationary pressure.
Infrastructure investments can withstand higher rates
Although infrastructure assets are diverse and subject to a wide range of macro-economic exposures, the performance of a well balanced portfolio of infrastructure assets is likely
to remain relatively robust through a forthcoming inflationary cycle. This should stand the sector in good stead as we move into 2022, given the increasing possibility that central banks will soon respond to accelerating inflation with tighter
monetary policy settings.
1 “InFRAME – an enduring methodology for building infrastructure portfolios”, Landman, Feb 2021
2 “Infrastructure investment in a rising interest rate environment”, Landman, Mathur, Sui, Aug 2018