Global Listed Infrastructure

The impact of inflation and

interest rates
By Trent Koch, Portfolio Manager

Global Listed Infrastructure | May 2021 For Professional / Institutional Investors only

Vaccine rollouts and government stimulus have led to expectations of higher economic growth,
inflation and interest rates. This has put pressure on listed infrastructure returns with the asset
class significantly underperforming global equities over the past 12 months. But with over 70%
of the investible universe able to pass through the cost of inflation to consumers, are these fears
overblown? Global Listed Infrastructure Portfolio Manager Trent Koch explains why inflation can
be positive for many infrastructure assets and how market uncertainty has created a compelling
investment case for the asset class.

Why are investors concerned about higher Transurban is a good example of a stock with this pricing power.
The company owns 21 toll roads in Australia and North America,
inflation today? most of which have the ability to increase tolls by inflation or
The COVID-19 pandemic caused the deepest global economic better.
recession in nearly a century. Global growth slowed,
unemployment increased and the transportation of people and Toll increases compared to CPI components Australia
goods were severely disrupted. In response, central banks and
governments are now seeking to aggressively stimulate their 10
economies. The likely results of this stimulus are increased global
growth and higher inflation. 9
It’s important to note that not all inflation is bad. Governments
around the world often target a 2-3% inflation range and most 8
countries have been trending well below that ‘ideal’ target band.
Inflation is concerning when it is sustained and aggressive, 7
because this can lead to economies becoming overheated. When
economies overheat, central banks often raise interest rates in 6
order to contain inflation.
5
Should rising interest rates worry investors
in infrastructure?
4

The characteristics of infrastructure assets (stable, long-life; cash 3

generative; low sensitivity to the economic cycle) makes them
relatively sensitive to changes in interest rates, compared to 2
global equities. 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
CityLink Education Beer CPI
Importantly, the impact tends to vary depending on whether rising
rates are being driven by higher inflation, or by real economic
CPI component indices rebased to CityLink toll A$
growth. Source: Bloomberg and First Sentier Investors
Data as at 31 December 2020
Inflation-driven
Where rising interest rates are a reflection of higher inflation, listed
infrastructure fares relatively well. Infrastructure companies have a
proven ability to pass through higher inflation to their customers
(typically with a 6 -12 month lag). Most infrastructure assets have
an explicit link to inflation through regulation, concession
agreements or contracts. Those assets without an explicit link
often have the pricing power to deliver a similar (or better)
outcome, reflecting their strong strategic position.

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First Sentier Investors I Global Listed Infrastructure
Real growth Degree of inflation protection by sector
Where rising interest rates reflect accelerating real economic
growth, listed infrastructure tends to lag as investors shift from 100%
defensive to growth equities. Evidence of this is illustrated in the
80%
following chart.
60%
Performance in Rising/Falling Bond markets
40%
1.5%
1.2% 20%
1.2%
0%
0.9%
Monthly average change

utilities

developed

Oil Pipelines

Airports

Towers

Freight Rail

utilities

Gas Pipelines

developing

Passenger Rail
Regulated

Integrated
Toll roads -

Toll roads -
0.6%
0.6%

0.3% 0.2%
Source: First Sentier Investors
0.0% Data as at 31 March 2021

-0.1%
What impact could higher inflation have on
-0.3%

-0.6% infrastructure assets?

MSCI TR Infra Index MSCI TR Infra Index
Rising bond yields Falling bond yields The impact of inflation on listed infrastructure assets depends on
a number of factors, including:
Benchmark is FTSE Global Core Infrastructure 50-50 Net TR USD Index from 1 April 2015
(previously UBS Global 50-50 Infrastructure & Utilities Index Net TR, USD). Type of asset
US 10-year Bond Yield Regulated assets such as utilities are more likely to have
Source: First Sentier Investors government agreements in place that dictate how costs can be
Monthly data from 31 Oct 2007 to 31 March 2021
passed onto consumers. They tend to be less sensitive to both
dips and peaks in economic activity, making them more defensive
The two halves of this chart show how global equities and listed
and well-positioned for a slowing economy. The benefit of
infrastructure have performed during periods of rising and falling
including such assets in a portfolio was demonstrated in 2020,
interest rates (represented here by US 10-Year Treasury yields)
when usage remained stable (relative to roads, air and rail) and
respectively.
revenue did not contract significantly.
The right hand side of the chart shows that in every discrete
For example, UK water utilities earn a real return on regulated
month since October 2007 in which US 10-year Treasury yields
assets, with inflation essentially being a pass-through. US electric
fell, global equities returned -0.1%, on average. The global listed
and gas utilities operate within regulatory frameworks which
infrastructure index performed better in this environment, rising by
enable them to earn an allowed rate of return on money spent
an average of +0.6% as infrastructure assets benefitted from the
maintaining or improving their asset base. While this rate is fixed
tailwind provided by lower rates.
for each regulatory cycle (which tend to last between one and
In contrast, when US 10-year Treasury yields rose, global equities three years), the allowed rate of return of the next cycle can be
delivered an average return of +1.2%. The global listed adjusted upwards if needed, to reflect a higher inflation
infrastructure index also on average delivered a positive return, but environment.
to a lesser extent, returning +0.2% on average in these months.
Agreements in place
Some contracts explicitly allow user costs to rise when inflation
Are infrastructure assets vulnerable to does. Others are more complex and look at a range of factors
higher inflation? beyond inflation, such as operating and capital expenses. The
nature of these contracts depends on the country, the type of
Some investors have taken the view that rising inflation will lead to asset and the regulations in place. Many toll roads, for example,
higher interest rates. This has put pressure on listed infrastructure have concession agreements that specify how prices can be
valuations. There are concerns that listed infrastructure increased, with an option to follow the Consumer Price Index (CPI)
companies may be forced to spend a higher proportion of their or an agreed percentage – whichever is higher.
earnings on interest payments; and that profits could be eroded
by rising inflation. Revenue drivers
In growth assets such as road transport, airports and rail, revenue
However, we estimate that more than 70% of the assets we invest is based on volume of users, and is therefore more sensitive to
in have the ability to pass inflation through to the end customer, economic activity. If the contract allows inflation and other
insulating investors from its impact. increased expenses to be passed on, then they are particularly
well-positioned in a rising inflation environment.
Inflation rate
For assets with an agreed price rise in their contracts, the actual
inflation level matters. For example, some mobile towers include
price escalators in their contracts at a set amount, e.g. 3%. If
inflation is lower than this, the asset owner benefits from the price
increase. Conversely, an inflation rate higher than this will
disadvantage the owner.

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First Sentier Investors I Global Listed Infrastructure
How does your portfolio change depending How has listed infrastructure performed
on inflation expectations? relative to inflation over time?
Part of our job as active managers is to take interest rate Global listed infrastructure has proved capable of delivering
expectations into account when positioning portfolios. We are returns well in excess of inflation. For the 15 years to March 2021,
able to shelter portfolios from the impact of rising rates by tilting listed infrastructure has delivered total returns of 8.5% pa,
away from “income” infrastructure sectors such as utilities; and equivalent to CPI plus 6.6%.
increasing holdings in “growth” infrastructure sectors such as
roads and railways. Listed Infrastructure Performance
While macroeconomic conditions play a part, the impact of
inflation also depends on particular companies and their assets. 500
As bottom-up investors, we look at the dynamics of the asset and
the sector, including barriers to entry, pricing power and structural 400
growth opportunities.
300
What are your thoughts on leverage for
infrastructure companies today? 200

It is understandable that investors are becoming concerned about

100
debt levels with potential interest rate hikes on the horizon.
Screening 0
Whether you are looking at a toll road, a tower or an airport, if you 2006 2008 2010 2012 2014 2016 2018 2020
take that defensive asset and put too much leverage against that Infrastructure CPI + 5% CPI + 8%
balance sheet, it is no longer defensive. So assets with too much
leverage are removed from our investible universe. We take a Infrastructure FTSE Global Core Infra 50/50 Net TR Index (USD)
CPI US CPI Urban Consumers SA
universe of roughly 250 companies and screen that down to ~125 Source: Bloomberg and First Sentier Investors
core infrastructure assets that we consider to be investible. Part of Quarterly time series from 2006-2021
that screening process addresses leverage, but we also eliminate
assets based on other factors. These include our view on The performance of global listed infrastructure during periods of
management quality, the capital structure and corporate higher inflation provides further evidence of the benefits that can
governance frameworks. be provided by this asset class. The chart below compares the
relative performance of infrastructure to global equities, when
Strong balance sheets
inflation is in a given band.
When analysing company leverage (and hence sensitivity to
changes in interest rates) we focus on a range of measures For example, when inflation is between 3% and 4% pa, global
including Net Debt to EBITDA, forward interest coverage ratio and listed infrastructure has outperformed global equities by around
refinancing risk. The strategy’s current weighted average Net Debt 4% pa on average. Importantly, this outperformance increases to
to EBITDA ratio is ~4.0x; a level we are comfortable with given the almost 8% pa when inflation is above 4% pa.
predictable nature of the cash flows being generated by our
holdings’ underlying assets. Infrastructure Performance During Periods of Inflation
Further, many infrastructure companies have taken steps to take
advantage of current low interest rates. We have seen significant 10%
refinancing of existing debt to lock in reduced rates, lengthen
maturities, spread refinancing risks, and diversify funding sources. 8%
The weighted average debt maturity on our top 10 holdings is
6%
currently over 10 years 1. That means debt has been locked in at
Infrastructure - Equities

very low levels for the next decade.

Relative 12M TR

4%
It’s important that infrastructure companies maintain appropriate
2%
debt structures so that when inflation does increase, they have
the ability to increase prices and see that flow through to the 0%
bottom line. It’s one thing to be able to pass on the costs of
inflation to the end customer, but if debt costs are rising by as -2%
much or more, the asset will be in a weak financial position.
-4%
Less than 1 - 2% 2 - 3% 3 - 4% Greater than
1% 4%
US CPI YOY

Infrastructure FTSE Global Core Infra 50/50 Net TR Index (USD) from Dec-05, prev Macquarie
Equities MSCI Daily TR Gross World USD
CPI US CPI Urban Consumers SA
Source: Bloomberg and First Sentier Investors
Quarterly time series from 2006-2021

1
As at 30 April 2021

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First Sentier Investors I Global Listed Infrastructure
Why is listed infrastructure a strong Conclusion
potential opportunity now? Investing in a portfolio of global listed infrastructure assets
2020 was clearly an unprecedented period in many ways, and it provides investors with exposure to assets including toll roads,
was a challenging year for global listed infrastructure. For just the airports, railroads, utilities, pipelines and mobile towers. These
second time in the last 15 years, listed infrastructure sectors share common characteristics like high barriers to entry
underperformed both global equities and bonds (global equities and pricing power. We estimate over 70% of the assets we invest
+15%, bonds +9%, listed infrastructure -4%). We now feel that in have the ability to pass through inflation to the end customer.
concerns around potential increases in interest rates have already Investor concerns around rising inflation and higher interest rates
been priced in. have been largely priced in providing investors with a compelling
case to invest in an asset class that we expect to provide inflation
We think our investment universe of utilities, toll roads, airports, protected income and strong capital growth for many years to
railroads and towers are well positioned today on a relative value come.
basis. And whilst we have maintained a cautious view of the
airports sector, we believe toll roads and railroads are well
positioned for a strong COVID-19 recovery as global economies
reopen.

Appendix: What does inflation protection look like by asset type?

We break down our ‘investment universe’ into four broad categories – Utilities, Transport, Communications and Energy Infrastructure.
The table below provides a summary of inflation protection by asset type.

Category Typical strategy Inflation protection

allocation 2

Utilities 50% North American utilities – Regulated return on investment methodology with allowed
returns moving with interest rates which implicitly incorporate inflation. Utilities file for a
rate case requesting costs such as inflation be passed through to the end customer.
Allowed ROEs have been in the 8-10% range historically despite falling interest rates.
European utilities – As a general rule regulation provides protection against inflation.
Key difference is if Weighted Average Cost of Capital (WACC) is determined in real
(adjusted for inflation) or nominal terms (fixed returns).
UK / Australia utilities – WACC is set in real terms with Regulated Asset Base (RAB),
Capital Expenditure (Capex) and Operating Expenditure (Opex) estimated and approved
by a regulator in real terms using inflation forecasts. Returns are then adjusted each year
for actual inflation.

Transport 30% Toll roads – Concession agreements for a defined period which specifies how inflation
will be treated. Agreements are often 30 years plus with explicit links to inflation.
Airports – Depends on the regulatory model of the airport. The majority of airports are
dual-till where aeronautical revenues are regulated with explicit links to inflation. Non-
aeronautical revenues are typically commercial agreements so depends on the contract.
Railroads – Freight rail rates are largely unregulated but strong pricing power allows
them to pass through many uncontrollable costs. Passenger rail revenue depends on
contract in place.

Communications 10% Mobile towers – US tower operators have contracted price escalators of ~3% per
annum. Contracts are typically 5-15 years in length. European tower operators have
contracts that are mostly linked to inflation.

Energy 10% Depends on the nature of the commercial agreement.

Infrastructure Oil pipelines – Typically have long-term contracts with annual price escalators
embedded in their terms.
Gas pipelines – Most contracts are take-or-pay but with fixed pricing hence more
exposed to inflation.

2
These allocations are indicative only and may vary over time.

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First Sentier Investors I Global Listed Infrastructure
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