Late last year, the US Federal Reserve lifted its benchmark interest rate from near zero to a new target range of 0.25 per cent to 0.5 per cent.
Furthermore, it is predicted that the Fed will raise rates by about one percentage point a year for the next three years.
How will listed infrastructure assets perform in a rising rate environment, will there be a price correction in these assets?
We think there will be a negative impact on some infrastructure asset prices, but there are many infrastructure assets where we believe the impact will be moderate or even favourable.
We only invest in what we call “preferred infrastructure” assets, many of which earn regulated returns based on their cost of capital.
As the cost of capital rises (or falls), so do their revenues. As a result, the earnings performance of these companies should be largely unaffected by rising rates.
Utility companies providing electricity, gas, and water in developed economies fall into this category.
However, not all preferred infrastructure assets are fully regulated. The earnings of some assets are affected by customer usage (eg. toll roads and airports), and these assets usually benefit from increased traffic growth in times when real interest rates are rising – assuming that the reason for higher interest rates is due to improving GDP growth.
In the case of inflation, toll roads usually have explicit linkages to inflation, and airports are also subject to regulated rates of return.
Therefore we would expect any negative cost impact of rate rises to be at least partially offset by inflation pass-through and higher revenue growth for these companies.
Therefore, we believe the impact of rising rates on preferred infrastructure will be cushioned somewhat by the inherent characteristics of these assets.
By contrast, we believe that infrastructure assets outside of our investment universe may experience significantly more price volatility as market discount rates often change without any accompanying change in earnings growth.
We believe these infrastructure assets will be more sensitive to higher rates and will face the likelihood of stock price falls.
A power generating company, for example, generally has no ability to pass through inflation and rate rises as their returns are not regulated, rather they are determined by the market.
Current valuations
We consider that parts of the infrastructure asset class are looking expensive. We have seen low market interest rates drive many investors to chase higher yields in equities which are perceived to have stable and defensive earnings streams.
This includes some portions of the infrastructure market. Higher interest rates may see some of these investors return to the bond market, sending the price of these seemingly stable stocks lower.
We think these concerns are most acute in North America, particularly in the US regulated utilities and the Canadian pipeline sectors. There are, however, areas of the market, particularly in Europe, that we think are attractively valued, even with higher interest rates.
Even at relatively high valuations and with the interest rate rises, we believe that it is possible to build a diversified portfolio of listed infrastructure companies that meet our return objectives, if one avoids the parts of the market that are expensive or particularly sensitive to higher rates.
Rising US rates are just one part of the economic picture facing the world today. They are an important consideration but not the only factor that will drive returns in the coming years.
Given the ongoing ambiguity about whether we are embarking on a period of inflation or deflation, accelerating growth or prolonged recession, we believe a listed infrastructure portfolio should be structured with a balance of stocks offering what we consider to be the highest potential returns while seeking to manage the risk of various macroeconomic outcomes.
In our opinion, preferred infrastructure should survive inflation or deflation and provide a reasonable relative return in the meantime.
In summary, we believe that a portfolio of preferred infrastructure holdings still looks relatively attractive, particularly when compared to a passive investment in infrastructure indices, bonds, or in broader equity markets.
Warryn Robertson is a portfolio manager and analyst at Lazard Global Listed Infrastructure.
