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The impact of increasing interest rates on listed infrastructure companies

May 2017

By Alex Stephen, Senior Portfolio Manager, Redpoint Investment Management

In a low growth, low return environment even relatively small interest rate changes can have a meaningful impact on investments. Therefore, investors looking to invest in listed infrastructure would have been interested in the recent moves by the US Federal Reserve (Fed) to increase interest rates by 0.25% in both December and March.

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. At the end of December 2016, the weighted average of total debt to total assets for the global share market was 23.5%1 compared to 42% for the infrastructure sector.2 This raises the concern that with their higher level of debt, infrastructure companies will have more sensitivity to increases in interest rates as their earnings will be negatively impacted. And 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.

Significant rate rises? Not just yet

There is little doubt that being overexposed to debt when 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 Charts 1, 2, 3 and 4 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. Therefore interest rates aren’t likely to run far ahead of inflation and we believe they should remain relatively stable.

Chart 1: North American cash rates

Source: Axioma and Redpoint Investment Management, as at 31 December 2016.

Chart 2: Australia and New Zealand cash rates

Source: Axioma and Redpoint Investment Management, as at 31 December 2016.

Chart 3: European cash rates

Source: Axioma and Redpoint Investment Management, as at 31 December 2016.

Chart 4: Developed Asia cash rates

Source: Axioma and Redpoint Investment Management, as at 31 December 2016.

Returns on bonds and cash yields remain low

Yields on treasury bonds are extremely low and in some cases negative (Switzerland, Germany and Japan). 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 can look appealing in this scenario despite the potential volatility, and investments in more defensive sectors, like infrastructure, look even more appealing. Relative to listed global equities and property, the infrastructure sector offers relatively stable cashflows, solid dividends alongside lower volatility and diversified returns, making a sound investment case. Charts 5 and 6 show firstly how the yields from infrastructure companies have been consistently higher than global equities, and secondly how much extra yield they have generated when compared to the local market cash.

Chart 5: Dividend yield from infrastructure companies relative to global equities

Source: FTSE, Axioma and Redpoint Investment Management, as at 31 December 2016. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.

Chart 6: Dividend yield from infrastructure companies and global equities in excess of local market returns on cash

Source: FTSE, Axioma and Redpoint Investment Management, as at 31 December 2016. Past performance is not a reliable indicator of future performance. The value of an investment may rise or fall with the changes in the market.

Chart 6 also shows the period of strong share price growth leading up to the GFC resulted in relatively low dividend yields. Dividend yields change significantly through time because they’re driven not only by dividends, which may be relatively stable, but also share prices, which are tied to market conditions.

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 by locking in lower rates for longer.

Summary

Investors are right to be wary of a rising interest rate environment. But it’s not all bad news. Investors should consider their investment objectives and portfolio strategy in light of a slowly rising interest rate environment. We believe in such an environment, well-managed infrastructure companies will continue to offer investors: inflation-linked income that’s higher than most other asset classes, lower volatility than broader global equities and the potential for capital growth.3 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 benefited 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.

Chart 7: Geographic diversification and number of holdings within the Redpoint strategy

Source: Redpoint Investment Management, as at 31 December 2016.

Interestingly, listed infrastructure is a relatively small subset of global equities, yet these companies are still a highly investible universe with A$2.2 trillion of market capitalisation.4 This is considerably larger than the Australian listed equity market at A$1.5 trillion.5

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.

 

1. As defined by the MSCI World Developed Index.

2. As defined by the FTSE Developed Core Infrastructure Index.

3. Any projection or other forward looking statement (‘Projection’) in this document is provided for information purposes only. No representation is made as to the accuracy of any such Projection or that it will be met. Actual events may vary materially.

4. FTSE Developed Core Infrastructure Index (FTSE Index), as at 31 December 2016.

5. S&P/ASX 200 Index, as at 31 December 2016
 

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