Infrastructure such as toll roads and airports play a central role keeping economies running.
These assets are also playing an increasingly central role in super fund portfolios, with investors attracted by the asset class’s attractive risk-return characteristics. They’re typically large, capital-intensive and quasi-monopolistic assets, which creates a rare mix of relatively high yet defensive returns.
But prior to 2020, some sought to label infrastructure as a ‘bond proxy’ given the asset’s consistent, long-term cash flows – and it benefitted from the rally in ‘bond proxy’ stocks.
Why infrastructure isn’t a bond proxy or hedge against rising inflation
Then, paradoxically, from 2022 others have labelled infrastructure as an ‘inflation hedge’.
To be fair, many labelled it as an inflation hedge well before 2022, but from 2021 when inflation was being labelled as “transitory” by Jerome Powell, the voices espousing the asset’s inflation hedging properties became much louder.
It’s another mental shortcut (or heuristic) that can easily sway investors into making poor decisions.
In fact, infrastructure can’t simultaneously be both a bond proxy and inflation hedge given they each have contradictory characteristics in a rising inflation environment. The value of an inflation-hedged asset will go up in a rising rate environment, whereas a sovereign bond’s value will go down1.
Infrastructure is a highly diverse asset class that is packaged in different structures, but its general performance doesn’t fit either description.
Figure 1: Sovereign bond index versus global infrastructure index versus Global Equities
Source: Bloomberg, Innova Asset Management
Infrastructure has its own unique risks
Infrastructure shouldn’t be compared to either bonds or inflation-linked assets because their cashflows are still economically sensitive. The cashflows may be more insulated than those produced by other assets, but they are still at risk.
In simple terms, fixed rate bonds offered by AAA rated Governments provide fixed coupons/payments for the life of the bond. Whilst nothing in life (or finance) is guaranteed, this is as close to a guarantee as you can get. However, the value of those coupons drop when inflation goes up as they are worth less in inflation adjusted, or ‘real’ terms.
A true inflation hedge is an asset that offers capital or cash flows linked to inflation.
Infrastructure assets often exhibit these qualities. However, many investors will often overlook the economic sensitivity of these assets.
For instance, even if an infrastructure portfolio has income perfectly linked to inflation, it doesn’t mean that profitability is guaranteed. This is because as inflation increases the cost of living, it may lead to reduced usage of the asset, thereby decreasing cash flows. This can happen even though, or perhaps because, their price is rising. This economic sensitivity is often missed, but we suspect that the market is now waking up to this reality.
We saw this unfold during the COVID-19 crisis when toll road and airport usage stopped, thanks to extended lockdowns.
A historic record government bailout eventually underwrote their operations and most of those assets have since bounced back, but it shows that their risk-return profile is not a proxy for sovereign bonds or even an inflation-hedge.
Certain infrastructure assets do have contracts that are priced to rise with inflation, but even these are typically capped below recent inflation levels. For example, tolls applying to Melbourne’s CityLink (which links the airport with the CBD) are capped at 4.25 per cent annually until mid-2029.
An attractive price increase for investors, but well below the most recent inflation peak which was above 7 per cent2.
It may not always be a large event such as a pandemic that impacts an infrastructure asset’s cashflows. The legislation that protects the cashflows of many infrastructure assets can also give rise to regulatory risk.
A recent example was the ACCC challenging the commitment deeds made by the NSW government in its 2013 sale of Port Botany and Port Kembla under a 99-year lease. It included compensation payments for a 50 year period if the competing Port of Newcastle developed a competing container terminal.
The ACCC lost the case, and this year lost the appeal, however the NSW government has also since passed legislation to extinguish the anti-competitive liability. While these type of infrastructure assets are still highly protected and attractive, they certainly aren’t bond proxies or an inflation hedge.
Risk and return still prevails
In case you’ve missed our recent post – take a moment to read our analysis of several economic indicators and find out what our team saw from an internal study we conducted into corporate earnings during market downturns in Markets, Economies, and the ‘R’ word.
Unlisted infrastructure in particular has propelled the performance of many super funds in recent years3.
But the rules of risk and return still apply: expecting equity-like returns with bond-like risk over the long-term is not sustainable.
In reality, the risk isn’t being appropriately recognised – when it finally is, the adjustment is often quick and painful. We saw infrastructure have such a moment following the 2008 Global Financial Crisis when a number of listed vehicles were borrowing heavily to prop up their cashflows and pay out dividends. A liquidity crisis put a quick end to the party.
Cash remains the most liquid and safe asset but the price for the past few years is negative real returns.
The benefit is the ability to move quickly when attractive investment opportunities arise. Climb the risk-return ladder into higher-returning assets and an investor no longer has guaranteed capital preservation.
Instead, the investor takes on more risk, such as volatility or illiquidity.
Infrastructure can’t do it all. It takes a deeper understanding of the characteristics of the sub-asset classes: an area such as communications infrastructure will have different drivers than say, toll roads, and certain assets will be more protected from competitive pressure than others.
There are no mental short-cuts to replace the hard work and analysis required to create a robust and diversified portfolio that performs through a range of market conditions.
1 Inflation erodes the purchasing power of a bond’s future cash flows. As bond yields compensate by increasing in a rising rate environment, the price of the bond falls. We assume credit risk is effectively zero as sovereign bonds are backed by the government.
2 The performance of CityLink, as with most infrastructure assets, still remains linked to broader economic factors and the rising price of tolls has the potential to reduce demand. Transurban’s May 2023 market update said CityLink’s recovery is ongoing, with workday peaks now returning closer to 2019 levels. See https://www.transurban.com/content/dam/investor-centre/04/2023-Investor-Day-presentation.pdf.
3 See Portfolio insights – why unlisted assets aren’t the simple solution that investors want, December 2022. https://innovaam.com.au/portfolio-insights-why-unlisted-assets-arent-the-simple-solution-that-investors-want/