Over the past six months, the 10 year inflation linked government bond has increased from -0.80% to 0.17% (the blue line in the chart below). This is an almost 1% increase in real rates! At the same time the nominal 10 year government bond has risen from 1.22% to 2.74% (green line) and, thus, the market implied breakeven has increased from 2.0% to 2.6% (orange line).
Higher interest rates are usually driven by higher expected inflation rates, and if there is a corresponding move in both, there is little effect on infrastructure valuations (as both net cash flows and the discount rates used to value them move higher).
However, if rates rise faster than inflation expectations, then real rates are increasing (as they have done over the past six months) the cost of capital is increasing at a faster rate than the project cashflows and valuations will likely fall.
The infrastructure asset class, like all risk assets, has enjoyed the strong tailwinds of falling interest rates (nominal and real) over the last three decades. Given the recent rise in real yields investors may be interested in how this reversal is likely affects the infrastructure asset class. This article looks at the relative sensitivity of various infrastructure sub‑sectors to rises in interest rates.
Not all infrastructure sectors are affected equally by rising interest rates. Across the subsectors there are differing revenue models, leverage levels and approaches to interest rate hedging. We summarise the broad infrastructure sub‑sectors below – patronage assets, regulated utilities, and public private partnerships.
Private public partnerships
For highly geared assets with fixed revenue lines such as PPPs with availability payments, there is no direct link to revenue and interest rates. However, due to the high level of gearing, projects are exposed to interest rates via debt interest payments and refinancing risk. Projects usually mitigate interest rate risk by entering into interest rate swaps for the full tenor of the concession. In general, PPPs are proxies for fixed rate bonds with fixed/defined operating cashflows and their valuation linked to the discount rate of those cashflows.
Investments in PPPs would be expected to suffer a significant return headwind in 2022 as valuations are updated on the basis of higher equity discount rates in line with higher 10 year bond rates.
Regulated utilities
As mentioned in the previous section, for most infrastructure assets there is no direct link between revenue and interest rates. The one exception is regulated utilities in Australia, where the allowable revenue is usually reset every five years as part of a regulatory review cycle. In general, this reset allows revenue equal to a regulated return on capital plus operating costs. This means that higher interest rates (all else equal) will feed through to higher revenues for regulated utilities, albeit with a lag linked to the regulatory reset process. The increase in revenue is in theory expected to match the rising cost of debt.
We would note that there is often not a direct passthrough of interest rate costs as often the actual debt costs are different to how the regulated WACC is calculated (backward looking regulatory method vs forward looking actual rates). Also, where investors acquire regulated assets at greater than 1x Regulated Asset Base (RAB) there is a valuation overhang that is uncorrelated to changes in interest rates. In a general sense, regulated utilities are generally a proxy for floating rate debt as revenues and funding costs move with interest rates. Interest rates effect the valuation component that is greater than the RAB.
Thus, while rising interest rates are likely to be a headwind for regulated assets, our view is that it wouldn’t be as material as for PPPs.
Patronage infrastructure
For patronage and economic assets revenue growth is driven by a combination of general economic growth, population growth and inflation. These assets have a higher growth profile and are likely to have the highest interest rate sensitivity due to the longer duration of cashflows. These concessions commonly have minimum levels of revenue escalation, for example Transurban’s CityLink guarantees a minimum 4% level of escalation under the concession.
Patronage assets tend to benefit from inflation as revenues grow at a higher rate. In the Transurban’s 2022 half year results management presented analysis showing that 68% of revenue had a 4.25% escalation floor and that a 1% increase in inflation would be a greater positive impact than any negative impact from a 1% increase in higher interest rates. The level of interest rates will however change the equity valuation via increased equity discount rate.
This analysis focuses purely on base rates and implicitly assumes that patronage or other revenue drivers are held constant. Other factors such as the Covid-19 pandemic may structurally change the demand profile of some patronage assets unrelated to interest rates and inflation. Separate to interest rates the biggest valuation driver of patronage assets is volume through the asset. These are the growth stocks of the infrastructure asset class!
Summary
In summary – infrastructure assets by the very nature of their low-risk long-term cash flows are sensitive to interest rates. This has been a massive and surprisingly consistent tail-wind for the performance of equity investments in the sector over the past decade of falling interest rates. Investors should be ready for potential head-winds (or at least gusts!) over the period ahead as higher risk free rates get reflected in asset valuations.
Comments