There is a common perception that infrastructure assets have a negative correlation to interest rates, ie, when interest rates rise, infrastructure company valuations fall. The main arguments for this view are as follows:
1) Infrastructure companies tend to use more debt than other companies, hence higher interest rates raises interest costs and decreases earnings
2) Infrastructure companies such as tollroads are bond proxies, so when bond yields rise, the price of bonds and bond proxies fall
3) Infrastructure companies have long dated assets and cashflows, rising real interest rates means the present value of long dated cashflows is reduced
We will outline RARE’s response to each of these in turn.
Infrastructure companies tend to use more debt than other companies, hence higher interest rates raises interest costs and decreases earnings
In RARE’s view, global infrastructure companies do not use substantially more debt than other sectors (high leverage has been a mainly Australian phenomenon). In addition, the long term nature of the assets has meant that most infrastructure companies in the portfolio have long term, fixed rate funding in place and are therefore not exposed to short term movements in interest rates.
Infrastructure companies such as tollroads are bond proxies, so when bond yields rise, the price of bonds and bond proxies fall
Tollroads are not exactly bond proxies. There is an important difference in that toll roads revenues are indexed to inflation. Bond yields are made up of a real component and an inflation component. If bond yields rise because inflation expectations are rising, tollroad asset prices will generally remain stable (or actually rise slightly) at the same time as bond prices will be falling.
Infrastructure companies have long dated assets and cashflows, rising real interest rates means the present value of long dated cashflows is reduced
Rising real interest rates are a major fundamental driver of asset returns. RARE includes an assessment of a company’s exposure to rising real interest rates in its fundamental stock research. The RARE portfolio is constructed in such a way that we maintain a reasonable proportion of companies that have the following characteristics:
• Both inflation protection and real interest rate protection - many asset regulatory regimes (especially in UK, US and European utilities) include interest rates in setting infrastructure asset returns. Hence asset returns and values are protected against rising inflation, rising real interest rates or both
• Exposure to economic growth – rising interest rates are ultimately a result of increasing economic growth (conversely interest rates fall in recessions). Assets such as ports, airports and rail will generally increase in value as the expectations of economic growth increase, offsetting the impact from rising rates.
Conclusion
Hence RARE is confident that:
• If interest rates rise over the next 6-12 months because inflation expectations increase, infrastructure as an asset class will benefit and the portfolio should reflect this
• If interest rates rise over the next 6-12 months because real interest rates are rising, the value of most assets will be negatively impacted (since all assets use real discount rates). However, in this scenario, we would position the RARE portfolio towards the more defensive, regulated utilities in developed markets to protect investor’s capital.
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