How does infrastructure investing hold up in inflationary times?

Infrastructure is often considered a compelling asset class, especially, during inflationary times for the consistent and dependable yields it can generate.

It generates this income from assets that enjoy significant barriers to entry, very long cash flow and that are usually the providers of essential services like water, transport, telecommunications and energy transmission which continue to be utilised whatever the prevailing economic situation.

Compelling investment characteristics

The essential infrastructure universe encompasses assets that are essential for the basic functioning of a society. They are usually regulated or have a track record of very stable cash flows through the economic cycle. This typically comprises monopolistic, regulated or long-term contracted assets, predominantly found in regulated utilities (electricity, gas and water), regulated or contracted pipelines, toll roads, airports and mobile phone towers.

Essential infrastructure carries minimal greenfield risk, ideally has no immediate competitors (and low bypass risk), has non-cyclical cash flows, and assets typically have negligible or appropriately low demand risk.

Essential infrastructure offers a compelling mix of yield, relative stability and long capital growth in the returns it offers investors.

On the income or yield side, listed global essential infrastructure assets demonstrate strong yield outperformance across most periods when compared to US government bonds also consistently offer a significantly higher yield than global equities.

Listed essential infrastructure assets have, since 2000, generated an average yield of 3.9% per annum (on a rolling basis), compared to the yield generated by global equities (MSCI World) of 2.3% per annum over the same period, and US 10-year treasuries of 3.2% per annum. On average, the global essential infrastructure yield has exceeded global equities by 1.6% per annum, and treasuries by 0.7% per annum.

Global essential infrastructure also offers comparatively stable yields with lower variability as evidenced by a standard deviation in yields of +/- 0.5%, similar to the variability in global equity yields of +/- 0.5%, but lower than the variability in 10-year treasury yields of +/- 1.3%.

Infrastructure yields in comparison to global equity returns

The unique cash-flow nature of infrastructure is such that equity investors in this sector forego some elements of growth, compared to what is on offer in global equities, in return for a higher relative yield. With essential infrastructure, yields are typically backed by large, real assets that hold dominant or allowable monopolistic positions in their respective markets’ real assets generating real yields.

For most essential infrastructure assets there is little to no competition or substitution, and yields are underpinned by contracts and concessions typically engineered and agreed with governments and regulators to allow for steady increases in revenue streams to cover operating and capital cost, and inflation rises.

One of the strong themes that can be seen in infrastructure earnings growth is that it is consistently positive across the cycle. This stability compared to the boom-and-bust pattern that can be seen in the earnings growth of general equities. While global equities can enjoy periods of superior earnings growth, a lot of benefit is given away in market drawdowns or when the earnings cycle goes into major contraction.

By contrast, the steady positive earnings growth shown in essential infrastructure compounds over the long term to significantly outperform the far more volatile earnings growth of general equities.

Infrastructure and inflation

It is critically important to note that the cash rate, and interest rates (relative to history) are very low and should remain low for some time even with some rate rises. This benefits equities in providing access to relatively cheap debt, funding for growth and acquisitions, and also assists private capital in the pursuit of listed companies.

Low rates are especially beneficial for infrastructure because of the leverage levels that can be supported by infrastructure’s long, mostly inflation-hedged, and stable cash flows.

The asset class has historically performed best under a moderate inflation backdrop. This has been the case as the moderate inflation will translate into healthy cashflow growth through CPI escalators or regulatory uplifts, while not causing significant changes to nominal base yields. With low interest rates still expected for a number of years even with monetary policy normalisation, the backdrop of strong growth and some inflation maintained within central bank guidelines is a ‘Goldilocks’ environment for the asset class.

Tim Humphreys is head of global listed infrastructure at Ausbil Investment Management.