Infrastructure – an income seeker’s solution in an inflationary world?

Infrastructure assets can offer income, in-built inflation protection and low correlation with the stock market and economic cycle.

| 10 min read

Traditionally, bonds offer a reliable income in a portfolio and some ‘ballast’ in the event of share market volatility. However, given very low yields and interest rates currently, they could be vulnerable as and when interest rates rise. If the tightening cycle is broader and longer than expected, bonds, especially longer dated and more highly rated debt, could lose significant capital value.

For investors seeking income, or a stable component to a portfolio that offsets equities, infrastructure investments could also help offer an alternative. Infrastructure provides the essential and services to support economic and social activity, for example, electricity, gas, water, transportation. Assets typically have an important strategic position and face less competition, so they may enjoy more predictable cashflows. Importantly, infrastructure companies can often raise prices without affecting demand much, plus contracts generally offer the ability to increase them with inflation meaning cash flows automatically adjust to higher prices in the wider economy.

Reliable income streams, but a complex area

Assets such as roads, power networks and public buildings are often backed by long-term revenue streams from local or central government. A motorway river bridge can, for instance, represent a near-monopoly route, and may have scope for raising toll prices over time, albeit there can be occasions, such as during the recent pandemic, when demand falls away.

Meanwhile, revenue from water, gas, broadband and other utility-style infrastructure tends to be fairly stable, and the provision of key buildings such as hospitals, schools and prisons are often uncorrelated to the wider economy all together.

Although a long term asset, infrastructure is constantly evolving and presenting new opportunities. The transition to net zero carbon calls for huge investment in new, more efficient electricity generation, storage and transmission, not to mention the huge roll out of charging points that the widescale shift to electric vehicles will bring. Meanwhile, heavy investment in high speed broadband is still necessary, notably in large swathes of the US.

However, it can also be a complex area and there are a number of risks to consider. Due to local or national importance, key infrastructure is often highly regulated. Although governments are often reliable, long-term partners, there is always the possibility they can intervene and, in extreme cases, reduce or constrain an investor's return, for instance through revoking licences or nationalising assets or projects.

Investing in infrastructure company shares through a fund

One route is to invest in shares of companies that operate infrastructure or vital utilities. Picking individual shares can lead to a lack of diversification, so another option is a fund specialising in these. They should offer a broad range of holdings by sector and geography while still producing a decent income from a flow of underlying dividends.

One option our Collectives Research Team rate highly in this area is FTF ClearBridge Global Infrastructure Income Fund. The management team are experienced infrastructure specialists based in Australia and have built an impressive record whilst consistently delivering a decent yield, though past performance is not a guide to the future. The fund invests in companies around the world operating in infrastructure related sub-sectors. The fund is exposed to both regulated assets (gas, electricity and water utilities) and to ‘user pay’ assets (toll-roads, airports, rail and communication towers).

Around 90% of underlying revenues in the portfolio are inflation linked, so the portfolio should be resilient in a scenario of higher inflation. However, it may be more vulnerable if economic activity drops off, particularly in respect of companies with ‘demand-based’ revenues, such as toll road operators and airports. The historic yield is 4.6%, but please note this is variable and not guaranteed.

Direct infrastructure through investment trusts

There are also lots of infrastructure opportunities outside the world of public markets. Infrastructure projects worth millions, if not billions, of pounds are not something an ordinary investor can get directly involved with, but there are ways to get around this. Specialist infrastructure investment trusts pool investors’ money and use their expertise to invest in a number of projects they think will make good long-term investments. The 'closed ended' nature of investment trusts makes sense for this area as it’s only really possible to finance projects with a fixed pool of capital committed for the long term.

Large, diversified investment trusts such as International Public Partnerships and HICL invest across a wide range of infrastructure assets in the UK and overseas. Their dividends can potentially provide investors with a decent income, derived from cash flows with a high degree of inflation linkage, and they could represent welcome diversification from equity and bond markets.

HICL Infrastructure invests in essential public assets – roads, water, schools and hospitals – mainly located in the UK but with some exposure to the Eurozone and North America. Diversification is also achieved via a mix of sectors, currencies and revenue models with the Trust combining complementary areas to mitigate exposure to any one factor, be it a single counterparty or macroeconomic trend.

HICL seeks to provide investors with long-term sustainable dividend income whilst also maintaining and growing capital for a 7-8% a year total return target. It has a higher yield than much of its peer group, but invests more in demand-based concessions which have a limit of 35% in the portfolio. These will have a higher economic sensitivity and toll roads such as the A63 Motorway in France and the Northwest Parkway in the USA saw revenues fall amid Covid-19 slowdowns.

HICL also has a stake in HS1, the rail link between London St Pancras Station and the Channel Tunnel, where the recovery of train revenue remains dependent on the further easing of international travel restrictions and an increase in cross border passenger demand between the UK and France, Belgium and the Netherlands. However, as the UK’s only high-speed rail link and the only rail connection between London and Europe, HS1 enjoys a unique strategic position and is well placed to benefit from a transition to a lower carbon economy as passengers seek to divert from short-haul flights to more sustainable transport modes.

As the economic recovery from the pandemic continues and the infrastructure sector evolves, we think the Trust is well placed to resume its record of dividend growth. The portfolio has about 70% invested in public-private partnerships, 20% in demand-based assets and 10% in regulated assets such as the stake in the Walney Extension ‘OFTO’ offshore transmission system, which serves the world’s largest offshore wind farm approximately 19km off the Walney Island coast in Cumbria. Under the offshore transmission owner (OFTO) regime, ownership is taken of an operational transmission asset and contractual, availability-based revenues over a 20-year period is received. This model does not have exposure to construction risk, electricity production or power price risk.

International Public Partnerships (INPP) invests directly and indirectly in public or social infrastructure assets (usually via entities which have been granted a concession to build, operate and manage those assets) and related businesses located in the UK, Australia, Europe and North America. It seeks to deliver sustainable long-term returns through growing dividends. Cash flows benefit from a high degree of inflation linkage and are very long term in nature. Unlike HICL, it invests almost exclusively in availability-based projects, rather than demand-based which have less predictable revenues. As such it has a heavy weighting in regulated assets.

Notable assets include the Thames Tideway Tunnel, London’s ‘super sewer’, and Diabolo Rail Link, which serves Brussels airport and has approximately 75% of revenues related to either the usage of the airport link or the wider rail system in Belgium. Although Diabolo does not provide train services, its revenue entitlement is linked to the number of passengers who use the rail link or the wider Belgian rail network, so this holding is a rare one in the portfolio that has suffered directly during Covid-19 lockdowns.

The Trust has also been moving into the digital space with projects such as Community Fibre, an internet service provider rolling-out fibre optic broadband networks across London. It is targeting social housing estates as a priority, where enhanced connectivity is opening up new opportunities for communities. Another internet service provider, Airband, brings high speed broadband to homes, business and industry in rural and hard-to-reach areas. Since its inception, it has connected over 3,000 rural businesses and 440 homes, helping to drive productivity, connect communities and reduce the digital divide in the UK.

The managers have stated that they continue to have a healthy pipeline of opportunities, having closed on Scotland’s largest operational offshore wind farm, Beatrice, in July, and over 40 potential investments currently under examination.

Our view

The global infrastructure sector has been growing for many years and is expected to continue getting bigger. For income investors especially, it remains an interesting alternative to more traditional components of a portfolio owing to the resilient, long-term, visible nature of cash flows, in-built inflation protection and low correlation with the stock market and economic cycle.

There is an element of political risk to bear in mind, and at a project or single company level there are a myriad of variables that can impact operations and profits. As with any investment area, diversification makes sense. There is also the general risk that assets with reliable income streams have become expensive in an era when bond yields have collapsed to exceptionally low levels. Should bond yields rise, that might only be partly mitigated by any inflation protection at a project or company level.

Please note funds mentioned have been thoroughly researched by Charles Stanley’s Collective Research Team, but none are part of our preferred list of funds for new investment at the time of writing.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Infrastructure – an income seeker’s solution in an inflationary world?

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