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The impact on infrastructure as interest rates rise


This note considers the impact of such a bond rate movement on both unlisted and listed infrastructure.


 

The US Federal Open Market Committee (FOMC) has given a clear indication it is open to a reconsideration of interest rates. This has implications for infrastructure assets and it’s important for self-managed super fund (SMSF) investors to understand what these are.

The minutes of the FOMC’s November 2016 meeting state, “the case for an increase in the federal funds rate has continued to strengthen.” However, the board notes it has, “decided, for the time being, to wait for some further evidence of continued progress toward its objectives.” The main objective is a lift in US inflation to 2% from its current level at 1.6%.

From an economic perspective this is good news. It suggests that FOMC is seeing signs of recovery in the US economy. However, many investors have invested in infrastructure because of its defensive characteristics. Valuations have increased as bond rates decreased, so it is important to consider whether an increase in bond rates will put infrastructure valuations under pressure.

While interest rate rises are on the cards, at least in the US, they are not expected to climb higher sharply and suddenly. While interest rates go up and down, the fragility of the global economic recovery means, unforeseen events notwithstanding, moderate interest rates are expected in the near term.

This note considers the impact of such a bond rate movement on both unlisted and listed infrastructure.

Debt Servicing costs

Due to the stability of their underlying revenues, infrastructure assets tend have moderate to high levels of gearing, relative to industrial stocks. So when interest rates rise, this can lead to higher debt servicing costs. Well-managed assets look to mitigate this risk through having a robust capital structure without excessive debt, and with loans of varying maturities and tenors from a range of debt providers.

In addition, some assets can also have significant levels of interest rate hedging in place.

These provisions mean that infrastructure cashflows are often fairly well protected against moderate bond rate movements.

Interest Rate Impacts on Unlisted Infrastructure Valuations

Unlisted infrastructure valuations are undertaken by independent specialist valuers who value assets by discounting forecast future cashflows by an appropriate discount rate to arrive at a net present value (or NPV). The discount rate the valuers select is based on a range of factors including comparable transactions, bond rates and market risk premiums.

Therefore, bond rates are an important component in the discount rate used in valuations.

This is the most important risk to valuations as the impact of movements in the discount rate (for example due to an increase or decrease in bond rates) on valuations can be very high. Simplistically, and in isolation, if bond rates reduce, asset valuations increase. Conversely, if bond rates increase, then asset valuations decrease. However, the key phrase here is “in isolation”. Unlisted infrastructure valuations are the sum of many moving parts, so nothing happens in isolation.

Other factors may offset bond rate movements. For instance, one of the reasons bond rates increase is because economic conditions are improving. This can translate to higher patronage or usage of the asset and therefore higher revenues. This may help counter potential negative impacts from higher interest rates.

In addition, valuation discount rates have tended not to reflect the full reduction in bond rates that have occurred over recent years, as the reduction in bond rates has been accompanied (or partially offset) by increasing risk premiums in the discount rates. Valuers have been effectively pricing in the risk of future interest rate increases. This has created a buffer in discount rates that we expect to see unwind as bond rates increase, which will help mitigate the impact of rising bond rates.

Typically, because of these hedging mechanisms, unlisted infrastructure assets demonstrate greater resilience to interest rate movements compared to many other assets.

For example, Melbourne Airport is a high growth infrastructure asset. Operationally, it is strongly leveraged to high growth Asian international air travel. It has grown its market share relative to other Australian airports, and seen strong growth from a range of passenger markets including 20% growth in FY 2016 in Chinese passenger numbers. Given current low levels of international travel per capita in the region, Asia Pacific air travel is expected to grow strongly, irrespective of regional economic growth. While an increase in interest rates could see the discount rate rise, Melbourne Airport’s high growth environment would likely mitigate this effect.

Of course different infrastructure assets will respond to bond rate movements differently, but as a general rule, growth assets will show higher resilience to moderate bond rate movements than yield assets.

Interest Rate Impacts on Listed Infrastructure Valuations

Interest rate impacts on market prices of listed infrastructure companies tend to be far more immediate than on fundamental valuations of unlisted infrastructure assets. This is because prices are heavily influenced by listed market sentiment. The short term speculator, who sets the market price, knows that a rise in interest rates is likely to have an immediate negative impact on market prices, and so sells in anticipation, irrespective of the impact on fundamental valuations or the intrinsic resilience of the asset.

Very broadly, listed valuations since the GFC of high yielding assets, such as utilities and listed PPP funds have shown a lower level of volatility than growth focussed assets. This makes sense in a low growth environment suggesting that many investors view the high yielding assets as bond proxies and mark down the growth assets in a low growth environment.

A rise in bond rates may reduce the appeal of the high yield assets and, if this is an indicator of better economic conditions, growth assets may benefit.

Portfolio considerations

The differences in valuation mechanics between unlisted and listed infrastructure can provide some good portfolio diversification opportunities. Given that overall listed market sentiment is not a major factor in unlisted valuations, unlisted valuations tend to be less volatile than market prices of listed infrastructure companies. Valuation movements can even be negatively correlated for similar types of infrastructure assets, depending on whether they are unlisted or listed.

Conclusions

About the author
John Julian is an Investment Director in AMP Capital's Global Infrastructure team, and the Fund Manager of the AMP Capital Core Infrastructure Fund. He has over 23 years financial sector and investment experience in both commercial and legal roles.
Greg Maclean is responsible for developing and managing AMP Capital’s infrastructure research capabilities, and conducts both macroeconomic and policy research, as well as detailed due diligence analysis for specific assets.
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