Infrastructure should be an investment for all seasons. The majority of infrastructure assets have stable, inflation-linked cash flows, often backed by governments. Yet it has been one of this year’s worst-performing sectors, laid low by rising interest rates and competition for capital with fixed income funds. But with discounts at historically wide levels, could this a good moment to re-examine the sector?
The average infrastructure investment trust is down 14.4% for the year to date (FE Fundinfo, to 13 August), while infrastructure securities trusts are down 14%. This puts them only marginally behind the volatile China and commodities sectors, and is unwelcome for a sector that is supposed to provide stability to a portfolio.
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A significant share of this weakness has come from a widening of the discounts – International Public Partnerships (INPP), for example, has moved from -5% at the start of the year, to -20% today, GCP Infrastructure Investments from -11% to -32%, and HICL Infrastructure from 0 to -27%. The open-ended funds have fared better, down just 6% on average.
Discount rate
The sector has been hit by a shift in the discount rate, which lowers the value of future cash flows. These had been highly prized in an environment of lower interest rates. Research from Killik last year showed that for every 1% increase in the discount rate, investors can expect a decline of between 5.4% and 9.9% in the NAV of these trusts. This has knocked share prices across the sector.
It is also the case that infrastructure trusts have been used as a proxy for fixed income investments while yields have been low, and capital has exited the sector now investors can get high yields on government and corporate bonds. Chris Morgan, investment director at Amber Infrastructure, investment adviser to INPP, says: “The trust has continued to perform well from an operational and financial point of view, but interest rates have been important – investors are looking at fixed income and its relative value.” This has hit sentiment and raised discounts.
However, as interest rates start to stabilise, it is worth looking at how infrastructure investment trusts stack up today. Wide discounts suggest there may be opportunities. The sector certainly appears to have merit for income investors, with seven out of the 10 funds in the AIC infrastructure sector trading at a dividend yield of 5% or higher. Some are substantially higher – GCP’s current yield sits at 9.5%, for example.
While this isn’t significantly higher than much of the government bond market – for reference, the yield on a two-year gilt is currently 5% – a crucial difference is that infrastructure assets generally have inflation-linked cash flows, even if the link is imperfect.
Morgan says: “Government bonds offer no inflation protection, while we have explicit inflation linkage.” That inflation protection should raise the value of future cash flows, and therefore compensate, to some extent, for a higher discount rate.
In a recent sector review, Winterflood points out that the yield pick-up for infrastructure is lower than normal: it has historically delivered a 350-420bps yield pick-up over 10-year UK Gilts, and is now around 178bps. However, it adds: “With several funds announcing higher dividend targets for 2023, this should support the relative yield differential versus gilts. Notably, the sectors exhibit a 17bps yield pick-up over UK Corporate bonds for Infrastructure respectively, and benefit from lower credit risk, longer dated cashflows, and indexed cashflows with the ability to increase dividends.”
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Richard Sem, a partner at Pantheon’s Global Infrastructure team, adds: “There are operating costs as well, which may rise in line with inflation, but there is a positive spread. As inflation increases, the gap increases. As such, infrastructure assets are a store of value during times of inflation.”
Infrastructure companies are not particularly exposed to rising interest rates in their day-to-day operations. GCP infrastructure, for example, makes fixed term loans, but these will be rolled over at higher rates as they expire. Others have rolling credit facilities, which are only used when they can achieve a higher return on assets. INPP uses interest rate swaps to hedge out some of the risk.
NAVs have shown some weakness, but have proved far more stable than share prices. Winterflood said: “The quarterly NAV reporting cycle began again in July… These updates have generally shown a markdown on portfolio valuations over the second quarter of the year, predominantly as a result of rising discount rates amid the higher interest rate environment.”
Selectivity
It appears there are some opportunities within the sector, but investors still need to be careful. James Klempster, deputy head of multi-asset at Liontrust, retains exposure to the asset class, but doesn’t see it as a ‘bargain’ just yet: “We have a diversified bucket of real assets, which includes infrastructure and we currently have it as a neutral weight. It is not a return driver, but it is less correlated to equities and can improve the overall efficiency of a portfolio.” He says that investors need to look carefully at the cost of funding for each trust.
It is also worth noting that the sector is changing, and this needs to be factored into an allocation to infrastructure. Morgan says: “A decade ago, a lot of the infrastructure assets were government concessions – schools, hospitals and so on. Over the last few years, it has moved into other infrastructure assets – renewables, digital infrastructure.” The vast majority of the IPPL portfolio remains in assets with visibility on cash flows, that are backed by governments, but a trust such as Pantheon Infrastructure will have more focus on development and asset management.
Infrastructure may not have delivered as expected over the past 12 months, but the adjustment may now be behind it as interest rates stabilise. While fixed income now provides more competition for capital, infrastructure’s inflation protection and diversification characteristics suggests it still merits a place in a portfolio.
