Infrastructure provides the essential and services to support economic and social activity, for example electricity, gas, water, transportation, and these assets are often a popular option with investors seeking stable returns.
Businesses operating vital infrastructure typically have an important strategic position and face less competition, so they may enjoy more predictable cashflows. Importantly, contracts generally offer some kind of inflation linkage meaning cash flows can adjust to higher prices in the wider economy.
Despite these underlying resilient qualities, many infrastructure investments have been adversely affected by the sharp and historic increase in interest rates and long-term government bond yields. Broad infrastructure investment trusts such as International Public Partnerships and HICL have seen share price falls of between 15% and 20% year to date, an uncomfortable ride for a traditionally defensive sector.
Why have infrastructure investment trusts performed poorly?
Higher rates and bond yields are the primary reason for weakness in the infrastructure sector. They negatively impact the sector in a few ways:
- Valuation of assets – Infrastructure investments are usually valued in reference to expected future cashflows using a ‘discount rate’ to reflect what could be achieved with the capital outlay with no risk attached. As government bond yields increase, the discount rate applied increases and so the present value of expected cashflows decreases. The valuation of assets will therefore reflect moves in long-term bond yields but do so gradually, with a lag, and will also account for evidence of assets being transacted in the market. If the market feels stated investment trust net asset values (NAVs) aren’t being adjusted quickly enough, it will tend to trade at a discount. There is a clear correlation between the performance of the infrastructure trust sector and the 10-year gilt (UK government bond).
- Cost of debt – Infrastructure trusts borrow money to fund projects. Short-term flexible borrowing tends to be through a revolving credit facility (RCF), which charges interest based on available bank rates. Higher interest rates means higher borrowing costs on RCFs, which impacts cashflow and could, in theory, undermine a trust’s ability to cover its dividend. Long-term debt at the project level is different because it tends to be long-term fixed rate, and many trusts stand to benefit from lower-cost debt secured when interest rates were lower.
- Investors are no longer starved of yield – A few years ago, infrastructure trusts were yielding 4.5-5.5% at a time when the banks and cash funds were offering close to nothing and short-term gilts not much better. Now investors can achieve 5% or more income on savings with virtually no risk. Interest rates might recede, and cash therefore carries the risk the level of return drops as interest rates change, but at the present time there is no longer scarcity of return from low-risk options, which reduces demand from alternative income sources such as infrastructure.
In addition, there appears to be selling pressure on UK assets more widely that is having an effect. Infrastructure make up a component of the FTSE 250 index of medium-sized UK companies, an index that is often used to express a negative view on the UK economy by more speculative market participants. Extra selling pressure in this area is an unhelpful technical driver that can weigh on share prices. There also seems to be ongoing selling from major holders, notably open ended funds that are seeing outflows.
What are the prospects for investing in infrastructure?
The above factors paint a bleak picture for the sector in the near term, but there are positives too. The underlying portfolios of infrastructure trusts retain some appealing characteristics in terms of their defensive nature and income generation substantively linked to inflation. This should allow dividend growth over time once Boards work through any immediate issues such as paying down now-expensive RCFs.
This can be done through cashflow or via asset sales, which judging by transactional evidence to date underpins the conservatism of stated NAVs. For instance, HICL achieved good prices for a portfolio of hospitals and schools, while The Renewables Infrastructure Group (TRIG) captured a significant premium to book value for three offshore Irish wind farms with an opportunity for repowering.
The past two years has been an uncomfortable reminder of listed infrastructure’s high correlation with bonds and equities in an environment of rising interest rates. But from this juncture it appears to us there is significant value in many of the infrastructure investment trusts, and they could be worth considering as part of a diverse portfolio. Given that central banks are done, or very close to done, on hiking rates, it is expected longer maturity bond yields will start fall as inflation continues to ease. In this scenario we’d expect a much more supportive backdrop for infrastructure trust share prices, although there is also the risk in the short term that rates rise further and cause further pain.
Presently, we do not include any infrastructure investment trusts on the Charles Stanley Direct Preferred List of investments, which is designed to provide a helpful shortlist of options in major fund sectors for those wishing to make new cash investments. The esoteric and more complex nature of the trusts, as well as the additional volatility associated with them being listed shares that can trade at a variable discount or a premium to their net asset value, makes them a generally riskier option in the areas compares with an open ended fund that invests in a diverse portfolio of stock market-listed infrastructure businesses.
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.
Is your investment portfolio working for you?
Our Financial Professionals can help you understand your investments, highlighting their performance and risk and giving you invaluable insight going forward.