March 2017
The impact of increasing interest rates on infrastructure companies
Alex Stephen, Senior Portfolio Manager, Redpoint Investment Management
The impact of increasing interest rates on listed infrastructure companies
In a low growth, low return environment even relatively small interest rate changes can have a meaningful impact on investments. So the recent move by the US Federal Reserve (Fed) to increase interest rates by 0.25% should be a consideration for investors looking to invest in listed infrastructure.
So why is it important? Firstly, infrastructure companies tend to be able to carry more debt than other companies due to the relatively sustainable and secure nature of their cashflows. As at the end of December 2016, the weighted average of total debt to total assets was 23.5% for global equities[1] compared to 42% for infrastructure[2]. This raises the concern that with their higher level of debt, infrastructure companies will have more sensitivity to increases in interest rates and their earnings will be negatively impacted. Secondly, if interest rates rise investors will move away from the currently appealing strong yield of equities and especially infrastructure companies and back into bonds and cash, impacting the companies’ share prices and therefore capital returns.
Significant rate rises? Not just yet
There is little doubt that being overexposed to debt when real interest rates rise quickly will have a negative impact on many companies’ returns, however we are currently very near the bottom of the interest rate cycle. As these charts show there has been little appetite for interest rate increases in the US or any other developed market, in fact the major economies of Japan and Europe are still operating funding programs to provide liquidity to their markets, Australia and New Zealand have recently just cut interest rates and the UK’s gradual recovery has been knocked by the vote to leave the European Union. Inflation remains stubbornly low across the world and it is hard to see this as a landscape for rapidly rising interest rates. Our expectation is that central banks are unlikely to significantly increase interest rates until there is a pickup in inflation so that nominal interest rates will not run far ahead of inflation and should remain relatively stable.
The impact of increasing interest rates on listed infrastructure companies
In a low growth, low return environment even relatively small interest rate changes can have a meaningful impact on investments. So the recent move by the US Federal Reserve (Fed) to increase interest rates by 0.25% should be a consideration for investors looking to invest in listed infrastructure.
So why is it important? Firstly, infrastructure companies tend to be able to carry more debt than other companies due to the relatively sustainable and secure nature of their cashflows. As at the end of December 2016, the weighted average of total debt to total assets was 23.5% for global equities[1] compared to 42% for infrastructure[2]. This raises the concern that with their higher level of debt, infrastructure companies will have more sensitivity to increases in interest rates and their earnings will be negatively impacted. Secondly, if interest rates rise investors will move away from the currently appealing strong yield of equities and especially infrastructure companies and back into bonds and cash, impacting the companies’ share prices and therefore capital returns.
Significant rate rises? Not just yet
There is little doubt that being overexposed to debt when real interest rates rise quickly will have a negative impact on many companies’ returns, however we are currently very near the bottom of the interest rate cycle. As these charts show there has been little appetite for interest rate increases in the US or any other developed market, in fact the major economies of Japan and Europe are still operating funding programs to provide liquidity to their markets, Australia and New Zealand have recently just cut interest rates and the UK’s gradual recovery has been knocked by the vote to leave the European Union. Inflation remains stubbornly low across the world and it is hard to see this as a landscape for rapidly rising interest rates. Our expectation is that central banks are unlikely to significantly increase interest rates until there is a pickup in inflation so that nominal interest rates will not run far ahead of inflation and should remain relatively stable.
Returns on Bonds and cash yields remain low
Yields on treasury bonds are extremely low and in some cases negative (Switzerland, Germany and Japan), and it will take several years of sustained increases in rates across the world to make these investments look appealing again to investors who are seeking an inflation beating level of yield. To achieve these returns in fixed income and cash, investors need to go up the bond risk curve and accept far lower quality investments. Equities look appealing in this scenario despite the potential volatility, and a defensive equity investment, like infrastructure, looks even more appealing. The relatively stable cashflows, the solid dividends alongside the lower drawdowns and diversified returns when compared to global equities or property make a sound investment case. The graphs below show firstly how the yields from infrastructure[3] companies are consistently higher than global equities[4] and secondly how much extra yield they generate when compared to the local market returns on cash.
Yields on treasury bonds are extremely low and in some cases negative (Switzerland, Germany and Japan), and it will take several years of sustained increases in rates across the world to make these investments look appealing again to investors who are seeking an inflation beating level of yield. To achieve these returns in fixed income and cash, investors need to go up the bond risk curve and accept far lower quality investments. Equities look appealing in this scenario despite the potential volatility, and a defensive equity investment, like infrastructure, looks even more appealing. The relatively stable cashflows, the solid dividends alongside the lower drawdowns and diversified returns when compared to global equities or property make a sound investment case. The graphs below show firstly how the yields from infrastructure[3] companies are consistently higher than global equities[4] and secondly how much extra yield they generate when compared to the local market returns on cash.
Infrastructure as a hedge against inflation
Also worth mentioning is that certain infrastructure companies can offer protection against increases in inflation. A sizeable portion of Redpoint’s portfolio is invested in regulated utilities. These companies are able to shield investors from rising inflation by passing through higher interest rate costs to their end consumers through inflation linked price increases. Regulators understand the needs of these companies to continually reinvest in their operations. The essential services they supply include; electricity, water, gas and waste disposal. Utility companies also tend to have very long term debt agreements, and the better managed companies have been taking advantage of the low rate environment by reducing the rates of their long-term debt facilities to lock in lower rates for longer.
We are acutely aware of these potential risks and opportunities and shape our portfolio to reflect them. As part of our portfolio construction process we rank companies on their sustainable quality. Sustainable quality uses traditional measures of financial strength such as free cashflow growth coupled with measures of management quality, such as the corporate governance structure, and handling of environmental and social concerns. We also rank companies on their levels of debt to enterprise value and we downweight those that we view as poor quality and those carrying excessive debt compared to their peers. In addition, our process ensures a lower level of stock specific risk than a typical active manager or indeed an Index manager. We hold around 120 companies in our portfolio, which is four or five times more than many active funds and our largest exposure is less than half the size of the largest in the Index. Our portfolio is therefore less exposed to the downside risks of any one company’s poor performance and truly does capture the essence of the asset class. The chart below illustrates how our investment process differentiates our returns from the Index by increasing the amount of stocks driving the outcome as well as highlighting the reduced stock specific risk embedded in both the Index and our peer group.
Also worth mentioning is that certain infrastructure companies can offer protection against increases in inflation. A sizeable portion of Redpoint’s portfolio is invested in regulated utilities. These companies are able to shield investors from rising inflation by passing through higher interest rate costs to their end consumers through inflation linked price increases. Regulators understand the needs of these companies to continually reinvest in their operations. The essential services they supply include; electricity, water, gas and waste disposal. Utility companies also tend to have very long term debt agreements, and the better managed companies have been taking advantage of the low rate environment by reducing the rates of their long-term debt facilities to lock in lower rates for longer.
We are acutely aware of these potential risks and opportunities and shape our portfolio to reflect them. As part of our portfolio construction process we rank companies on their sustainable quality. Sustainable quality uses traditional measures of financial strength such as free cashflow growth coupled with measures of management quality, such as the corporate governance structure, and handling of environmental and social concerns. We also rank companies on their levels of debt to enterprise value and we downweight those that we view as poor quality and those carrying excessive debt compared to their peers. In addition, our process ensures a lower level of stock specific risk than a typical active manager or indeed an Index manager. We hold around 120 companies in our portfolio, which is four or five times more than many active funds and our largest exposure is less than half the size of the largest in the Index. Our portfolio is therefore less exposed to the downside risks of any one company’s poor performance and truly does capture the essence of the asset class. The chart below illustrates how our investment process differentiates our returns from the Index by increasing the amount of stocks driving the outcome as well as highlighting the reduced stock specific risk embedded in both the Index and our peer group.
Summary
Investors are right to be wary of a rising interest environment but should consider their investment objectives and portfolio strategy in light of a slowly rising nominal interest rate environment and even slower rising real interest rate environment. We believe well managed infrastructure companies will continue to offer investors; inflation-linked income flow above most other asset classes, lower volatility than broader equities and the potential for strong capital growth. Redpoint’s carefully considered investment approach is designed to mitigate the downsides of a rising interest rate environment while using it as an opportunity to add value for investors.
A case for global infrastructure
While investing in infrastructure is usually associated with government spending or private equity companies, astute Australian investors have also benefitted from the asset class by accessing quality listed infrastructure companies.
However, while Australia is home to a few of these companies there are simply not enough of them and there is too little variety to make it an attractive stand-alone investment. There are currently 153 companies in the FTSE Developed Core Infrastructure Index of which only 8 are Australian companies. By expanding the universe to include all developed markets the investment characteristics of global infrastructure are far more appealing both in the context of diversification benefits and in delivering less volatile retirement income streams. The table and graph below shows the geographic diversification and number of holdings within the Redpoint strategy at the end of December 2016.
Investors are right to be wary of a rising interest environment but should consider their investment objectives and portfolio strategy in light of a slowly rising nominal interest rate environment and even slower rising real interest rate environment. We believe well managed infrastructure companies will continue to offer investors; inflation-linked income flow above most other asset classes, lower volatility than broader equities and the potential for strong capital growth. Redpoint’s carefully considered investment approach is designed to mitigate the downsides of a rising interest rate environment while using it as an opportunity to add value for investors.
A case for global infrastructure
While investing in infrastructure is usually associated with government spending or private equity companies, astute Australian investors have also benefitted from the asset class by accessing quality listed infrastructure companies.
However, while Australia is home to a few of these companies there are simply not enough of them and there is too little variety to make it an attractive stand-alone investment. There are currently 153 companies in the FTSE Developed Core Infrastructure Index of which only 8 are Australian companies. By expanding the universe to include all developed markets the investment characteristics of global infrastructure are far more appealing both in the context of diversification benefits and in delivering less volatile retirement income streams. The table and graph below shows the geographic diversification and number of holdings within the Redpoint strategy at the end of December 2016.
Interestingly, listed infrastructure is a relatively small subset of global equities, yet these companies are still a highly investible universe with $2.2 trillion of market capitalisation[6]. This is considerably larger than the Australian listed equity market[7] at $1.5 trillion.
Also, the benefits usually associated with infrastructure assets, namely a stable and growing dividend stream, and lower volatility, means the asset class is particularly suited to a wealth preservation-focused, ageing demographic moving from accumulation to retirement.
Investors can choose direct investment or through the listed equity market. There are significant benefits of investing through the listed market, namely; daily liquidity, daily valuations, no drawdown or lock up periods and increased diversification. While investors in listed markets are likely to experience more short-term price volatility, (due to the daily mark to market of listed securities versus unlisted), long term returns will be driven by the nature of the underlying assets.
Also, the benefits usually associated with infrastructure assets, namely a stable and growing dividend stream, and lower volatility, means the asset class is particularly suited to a wealth preservation-focused, ageing demographic moving from accumulation to retirement.
Investors can choose direct investment or through the listed equity market. There are significant benefits of investing through the listed market, namely; daily liquidity, daily valuations, no drawdown or lock up periods and increased diversification. While investors in listed markets are likely to experience more short-term price volatility, (due to the daily mark to market of listed securities versus unlisted), long term returns will be driven by the nature of the underlying assets.
Footnotes
[1] As defined by the MSCI World Developed Index
[2] As defined by the FTSE Developed Core Infrastructure Index
[3] Developed Core Infrastructure Index (FTSE Index), as at 31 December 2016
[4] As defined by the MSCI World Developed Index
[5] Average weights of a representative sample of five (5) managers in the listed infrastructure peer group.
[6] FTSE Developed Core Infrastructure Index (FTSE Index) at 31st December 2016
[7] S&P ASX 200 Index as at 31st December 2016
[1] As defined by the MSCI World Developed Index
[2] As defined by the FTSE Developed Core Infrastructure Index
[3] Developed Core Infrastructure Index (FTSE Index), as at 31 December 2016
[4] As defined by the MSCI World Developed Index
[5] Average weights of a representative sample of five (5) managers in the listed infrastructure peer group.
[6] FTSE Developed Core Infrastructure Index (FTSE Index) at 31st December 2016
[7] S&P ASX 200 Index as at 31st December 2016
Important information : This communication is provided by Redpoint Investment Management Pty Limited (ABN 83 152 313 758, AFSL 411671) (Redpoint). The information in the communication is of a general nature only and is not financial product advice. The communication is not intended to offer products or services provided by Redpoint or its affiliates. Opinions constitute our judgement at the time of issue and are subject to change. Neither Redpoint nor its employees or directors give any warranty of accuracy or reliability, nor accept any responsibility for errors or omissions in this communication.