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Infrastructure in rising interest rate environments
With varying degrees of resolve, central banks in major economies are tightening monetary policy in response to record high inflation. As investors adapt and adjust for the regime shift, we believe investment in infrastructure – as a countercyclical asset class driven by essential social needs – will continue to demonstrate its performance resilience through this macro change.
As a long-duration asset class, infrastructure is sensitive to interest rate changes. But the relationship is complex. The impact depends heavily on what spurred the interest rate increase in the first place, how quickly and for how long the rates moved.
Why interest rates matter?
The two most obvious reasons why rates matter are financing costs and the impact of discount rates on valuations. Duration measures the sensitivity to interest rates, and the present value of assets with longer term cash flows by definition is more sensitive to shifts in market discount rates. Following the pandemic, certain infrastructure sectors such as airports are entering the new rate regime with structurally higher debt levels.
The returns of all major asset classes – equities, bonds, unlisted and listed infrasructure – are negatively correlated with corporate borrowing rates. However, both listed and unlisted infrastructure are less at risk from widening credit spreads than general equities, as the asset class’ mostly investment grade profile has led to a more muted rating impact in different credit cycles. Infrastructure companies also tend to lock in longer term debt so they are less exposed to refinancing risk at the short end of the rate curve. Over time, the average maturity has shortened, likely as a result of the expanded definition of the asset class and the entrance of more service-oriented companies with lower debt tolerance. Furthermore, years of ultra-low interest rates and the pandemic-fuelled cycle in 2020 led to only a moderate spike in leverage for the asset class.
Refinancing risk and covenant breaches
Infrastructure entities with higher leverage and tighter covenants such as airports are most-at-risk while regulated utilities with stronger pass-through capacity are most resilient. Investment strategies focused on prudent capital structure management, laddering debt maturies and proactively locking in fixed rates for longer will pay off in the current rate environment. As the market is not anywhere near consensus about the pace and peak of the rate trajectories, there is also a risk of asset mis-pricing if investors fail to swiftly factor in the steepening rate curve in valuations.
Discount rate is only one factor affecting valuations
An increase in interest rates impact discount cash flow (DCF) valuations negatively across the board. However, changes in expected dividend cash flows and equity risk premiums also impact valuations. Core-plus and mid-market strategies experienced the lower negative valuation impact, as higher interest rates were offset by higher expected dividends, according to unlisted infrastructure strategies computed by EDHECInfra, the data provider. Core-plus strategies tend to have relatively more stable cash flows than opportunistic strategies and are expected to benefit from the on-going pandemic rebound in certain sectors, such as transport, and the slowing, but still positive, global economic growth.
Infrastructure also outperforms general equities during falling interest rate periods. This is because infrastructure entities provide essential services often under regulated or long-term contracted arrangements. The built-in downside protection supports cashflows during times of contracting economic output. As it stands, rising rates are in some regions one of a triple whammy alongside high inflation and exceptionally high and volatile power prices. While we expect the infrastructure industry to be able to pass through financing, capital and operating cost increases better than other corporate sectors, this will vary by company and jurisdiction. Affordability, political scrutiny and the tolerance by regulators for rate hikes will determine the outcome. On the other hand, strong secular trends, such as the ongoing digital transformation and consumption of data, will help infrastructure segments such as data centres, fibre networks and towers to navigate the cost impact with minimum re-adjustment of investment spending.
Assets providing essential services will remain resilient during reduced disposable household income (e.g. for utilities providing water, electricity or heat). Sectors with strong inflation pass-through (unlisted social infrastructure, network utilities) or link to commodities (power generation, midstream energy) have outperformed the broad-based indices in a high-inflation, low-growth periods. Structurally, infrastructure also stands to benefit from the accelerated energy transition, decarbonisation and digitalisation as well as general government stimulus and post-pandemic support. The secular tailwinds and long-term essential needs underpinning infrastructure investment lead us to believe that higher funding costs will not change materially the investment growth outlook.