Rising rates and infrastructure

A common dictum of global listed infrastructure that when interest rates and inflation rise these securities underperform. On the contrary earnings from assets such as toll roads are inflation linked and utilities often benefit from regulated price increases which shield the return on assets from the effects of inflation and interest rates.

Infrastructure in a rising rate environment

Last week the Fed raised interest rates for only the third time since 2008 and the second time in four months.  In a rising rate environment, income producing assets such as bonds generally perform poorly.  This is not the case with all infrastructure assets.

Many infrastructure assets such as utility companies providing electricity, gas, and water have earnings that are regulated based on their cost of capital.  As the cost of capital rises (or falls), so do their revenues. As a result, the earnings performance of these companies should be largely unaffected by rising rates. Some infrastructure assets such as roads are also often linked to inflation.  

Additionally, the earnings of some infrastructure assets are affected by customer usage such as airports, and these assets usually benefit from increased traffic growth in times when real interest rates are rising – assuming that the reason for higher interest rates is due to improving economic/GDP growth.

Infrastructure returns during the most recent rising rate environment

Contrary to common belief, history shows infrastructure stocks can perform well when interest rates start rising. When the Fed started its last hiking cycle in 2004 global listed infrastructure returned 33.41% in the year following. Even in the short-term, with expected price weakness, performance was 8.26% in the 3 months following the first 2004 rate hike. The same index had seen a 4.05% rise after the first hike in December 2016.

Table 1: Infrastructure Index post the Federal Reserve rate rises

^{Source: Bloomberg, Morningstar, Infrastructure Index is S&P Global Infrastructure Hedged to AUD Index and has been used as it has the longest calculation history. 3 months periods are 1 June 2014 to 31 August 2014 and 1 December 2016 to 28 February 2017. 6 months period is 1 June 2014 to 30 November 2014. 12 months period is 1 June 2014 to 31 May 2015. Past performance is not a reliable indicator of future performance.}

Graph 1: US 10 year yield vs FTSE Developed Core 50|50 Infrastructure $A Hedged Index (‘IFRA Index’) – Jan 2006 to Feb 2017

^{Source: Bloomberg, period 31 January 2006 to 28 February 2017. Infrastructure Index has been rebased to 1000 and is the FTSE Developed Core 50|50 $A Hedged Index. US 10 year yield is the US Generic Government 10 year yield. Past performance is not a reliable indicator of future performance.}

When rates rise there is typically short-term price weakness but this potentially represents a good buying opportunity. However, there is more to the relationship between the performance of global listed infrastructure securities and rates/inflation.

On Wednesday night the Fed raised rates which was anticipated by the market. However, markets responded by unwinding positions that anticipated rapid rate rises with long term yields falling.  Market forecasts were dampened as Fed Chair Janet Yellen indicated the pace of future tightening would be more gradual.  

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