Infrastructure investment in a rising interest rate environment
Institutional investment in infrastructure has seen significant growth in recent years. Following an extended period of quantitative easing from central banks, investors are now entering uncharted waters as interest rates are rising. IFM Investors
looks at factors affecting infrastructure investments which can reduce the impact of rises in interest rates, particularly where there is a natural hedge through linkages to inflation or economic growth.
Institutional investment in the infrastructure asset class has seen significant growth in recent years. This dynamic can largely be attributed to investors looking to access investments with attractive risk-adjusted returns, and a strong and stable
cash yield in an otherwise relatively low-yield environment across traditional asset classes.
But investors are now entering uncharted waters, with rates rising following an extended period of quantitative easing by central banks. Key questions for the infrastructure asset class are:
- How quickly and how high can rates rise; and
- How will investments in infrastructure perform in this environment?
This paper begins with a brief summary of the macro-economic environment which has led to historically low rates and examines the outlook for rates going forward. The view presented remains consistent with the work of IFM Investors Chief Economist,
Alex Joiner, published in February 20181.
We then present IFM Investors’ views on the characteristics of the unlisted infrastructure market and our global infrastructure portfolio in the context of increasing rates, as well as changes in other key macro-economic variables. Key areas
- How debt financing of investments can be structured to somewhat mitigate or delay the impact of rising rates;
- The natural hedge provided by some infrastructure investments where performance is linked to inflation and economic growth;
- How discount rates (which drive valuations and performance) are expected to react in a rising rate environment;
- The potential secondary effects of rate rises flowing through to demand for infrastructure services, caused for example by pressure on consumer discretionary spending; and
- Pulling these factors together, how can IFM Investors continue to “buy well” and optimise the global portfolio in the context of the economic outlook.
Asset valuations across all sectors, including infrastructure, have benefited from an extended period of interest rate declines in advanced economies over the past 30 years
The interest rate environment
Asset valuations across all sectors, including infrastructure, have benefited from an extended period of interest rate declines in advanced economies over the past 30 years. This occurred as part of a structural lowering of policy interest rates
as central banks across the globe adopted inflation-targeting regimes and inflation itself was brought under greater control. Since the Global Financial Crisis, rates have been lowered even further, in an effort to drive economic recovery.
The low yield available in fixed interest markets has meant increased institutional demand for exposure to higher-yielding sectors such as real estate and infrastructure. These sectors have largely benefited from the attractive cost of investment
grade debt financing, as illustrated for the US market in Graph 1.
1 IFM Investors February 2018 Economic Outlook.
GRAPH 1 - US 10-YEAR TREASURY YIELDS & CORPORATE BOND SPREAD. Source: Bloomberg. Past performance does not guarantee future results.