Infrastructure equity in rising rate environment
This year in financial markets marks not only the return of volatility, but also rising interest rates – something investors had not seen for a decade. Naturally, this backdrop raises debates about a number of investments, among which infrastructure equity is no exception. This article discusses what rising rates mean for infrastructure stocks, and why the financial profile of these companies should not be viewed as bond-like in the context of rates.
The rate hikes
To be fair, the markets were already reminded that interest rates would not remain at near-zero lows forever at the end of 2015 when then chair of US Federal Reserve Janet Yellen announced the Fed’s first rate hike since 2006. It was argued that the economy has “come a long way”, but caveated with normalization “is likely to proceed gradually”, and “inflation continues to run below longer-run objective”1. Fast forward to June 13 of this year, and we saw the seventh consecutive rate hike, all in a linear fashion with 25 basis point increments. According to the Fed themselves, one to two more hikes in a similar manner are still to be expected this year.
At the end of the day, it's not a normal condition to have interest rates at zero.
Lloyd Blankfein, Goldman Sachs CEO2
Last time a similar adjustment was between 2004-2006 when rates rose from 1.25% to 5.25%. At the current range of 1.75%-2.00% we are a considerable distance from those pre-financial crisis levels, however it is fair to say that the quantitative easing is clearly now in reverse. This tightening rate policy by the new Federal Reserve chairman Jerome Powell can be viewed as a “return to normal” - smoothing the cycle, so to speak. In the meantime US has seen an impressive reduction in unemployment rate from 8.9% in 2011 to just 4.4% last year while average salaries have been growing steadily at 1.9-2.7% year on year3.
There is a broad view that rising rates pose a particular challenge for infrastructure investments. The relationship on the face of it is simple – the cost of capital for companies goes up, and interest expense puts pressure on earnings. While this is true for all companies, infrastructure stocks tend to have more debt on their balance sheets due to the higher capital requirements for building the underlying assets, and hence should see a greater impact. Moreover, the higher interest rates affect the future cash flows generated from infrastructure projects, as higher discount rates are applied.
Given their dividend policies, many infrastructure companies are regarded as a bond proxies together with grocery stores and soap manufacturers – predictable stocks with predictable dividends. Rising rates are therefore bad news for these stocks, as the attractiveness of their dividend yields deteriorate and respectively owning equity risk in return for now subpar yield becomes unattractive. This in turn puts further pressure on the equity price.
Does the market agree?
As with many things, in reality the relationship between interest rates and infrastructure equity is not as straightforward. Looking at the not-so-distant history, both global stocks (as measured by MSCI World Index) and infrastructure (NMX Composite Index) managed to perform well over 2004-2006 hikes, but, more importantly, infrastructure outpaced the general market with 27.3% against 15.7% return on annualized basis. In the beginning of the current rate-hike period, infrastructure performed in line with broader market, however now is trailing by 4% annualized, having seen the strong growth in technology stocks from 2017 onwards. Historically, in the ten largest US 10-year T-bill upward movements infrastructure has outperformed the broader market on one-year basis after an initial lag4.
The absolute returns could be generally explained by rising rates coinciding with periods of accelerating economic activity. But perhaps something is slightly odd in this picture, and drawing parallels to bond reactions during rate hikes then means missing a part of the argument?
Interest rates have to be viewed in the context of inflation, as the pickup in yields implies a pickup in expected inflation which the rates are designed to counterbalance. Fixed income holders are understandably more concerned with the real rather than nominal interest rates, as inflation decreases the future purchasing power of their cash flows.
The financial profile of many infrastructure companies may roughly resemble that of a fixed income instrument: invest principal money up front to build the infrastructure and receive a steady stream of cash flow to the level of demand in the overall economy. Unlike fixed income instruments, however, infrastructure companies typically enjoy strong inflation protection in their contracts (in contrast to companies in, say, consumer sectors), enabling them to adjust the pricing of their service based on a common measure like Consumer Price Index (CPI). In an environment of falling real rates (inflation rising faster than rates) infrastructure companies would benefit.
What might be underappreciated is that in the short to medium run the actual costs for these companies increase less than the inflation. Once the infrastructure is built and financing locked in, the affected operational costs are a considerably smaller part. These arguments are especially true on the more regulated end for energy companies and toll road operators. Similar logic applies to capital cost increases, as companies with regulated contracts can pass these differences to consumers.
A middle-of-the-road example is Waste Connections, a Canadian waste collection, disposal and recycling company. It has about 35%-40% of its sales tied to CPI or a waste-specific inflation index, so they are partially protected in this sense. They also are able to partially offset higher fuel prices through surcharges to customers. That said, about 60%-65% of its business is longer-term, but still open-market pricing, on which Waste Connections typically try to achieve more than 3% annual price escalation to cover inflationary costs (particularly labour). This leads to operational leverage and increase in profitability as inflation accelerates.
Borrowing costs and growth
Regarding impact of increasing rates on borrowing costs, the current flattening of yield curve is actually constructive for long-duration issuers such as infrastructure companies. It provides the right incentive for longer-term financing, and this benefit is ultimately passed to equity holders, while the short term rates are often irrelevant for financing multi-year projects. Of course, debt structures differ widely from company to company and so do the potential gains and losses from managing the term structure in this environment. The important takeaway, however, is that the rate hikes concern much more the shorter end of the curve and hence inflation, while the longer end concerns growth.
E.ON, a German energy generation and distribution company, illustrates these nuances. Term structure is constructed to match the financing needs and manage the risk over the longer run. Hence the short terms rates do not have as big of an impact, and E.ON is expected to continue to be able to decrease debt costs in the foreseeable future by refinancing at lower rates than they were able to in the past - even in a rising rate environment.
Then there is the growth element in the mix. As the economic environment offers opportunities for infrastructure companies that have a strong growth pipeline, we are seeing increasing rather than bond-like, stable cash flows. American Towers is one such example. The owner, operator and developer of wireless communications towers has seen 18% CAGR in revenues over the last five years.
The increasing short term rates then do not have a clear effect on infrastructure equites, as it does not fundamentally drive up the borrowing costs for these long-maturity issuers. Not all infrastructure stocks are equal, however, and the quality of the debt structure on company level is what matters. The same applies for inflation protection in contracts and taking opportunities of growth that expanding economy offers.
At the end of the day, stock market is driven by sentiment arguably just as much as fundamentals. The initial worry of rates picking up might dampen infrastructure performance – a self-fulfilling expectation – however, history shows that a return to fundamentals is not far behind, as many infrastructure companies find benefits in the environment of increasing inflation and rates.