Challenging the ‘bond proxy’ thesis

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The idea that infrastructure assets are ‘bond proxies’ and will perform poorly when interest rates rise is an overly simplistic view of the asset class and its dynamics, a leading infrastructure fund manager says.

This issue has had plenty of airplay since December last year, when the US Federal Reserve raised its target funds rate by 25 basis points. The Fed raised rates again in March and in June.

RARE Infrastructure head of Australian retail, Steve Williams, says: “You have to look at what is causing rates to go up. If they are being driven up by increased economic activity, user-pays assets can benefit.

“For example, toll roads will get more traffic volume and this will offset the impact of the rise in interest rates.

“The important question is whether the underlying cash flows from the infrastructure business are impaired in a rising rate environment.”

Investment management researcher Morningstar supports this view. In a recent commentary, it pointed to the fact that the S&P Global Infrastructure Index has risen more than 10 per cent over the past 12 months, despite the Fed’s tightening of monetary policy.

“One reason for this is that rising interest rates may be an indication of a growing economy. Infrastructure companies that are linked to consumer behavior usually benefit from increased demand,” Morningstar says.

“History has shown that global listed infrastructure securities can perform well after an interest rate hike.”

RARE infrastructure, which is an affiliate of Legg Mason Global Asset Management, was established in Australia in 2006. It offers four funds in Australia – all investing in listed global infrastructure assets.

Williams says the Australian market does not have sufficient depth or diversity to support a standalone portfolio.

The RARE Infrastructure Income Fund, which targets a net distribution yield of 5 per cent a year, produced income of 5.2 per cent over the 12 months to the end of August and a total return of 14.1 per cent.

Williams says a total return of 8 to 10 per cent is a more realistic target over time. All four funds are benchmark unaware and have an absolute return focus.

There are a couple of local listed infrastructure companies in the fund, including Spark Infrastructure, which holds a portfolio of electricity, gas, water and sewerage businesses, and AusNet Services, an electricity transmission company.

Williams says: “The companies we invest in must meet three key criteria, First, the asset that the company owns must be a hard, physical asset. Second, this hard asset must provide an essential service to society or the economy. Finally, there must be a robust framework in place to ensure that we, the equity holders of these companies, get paid.

“This framework can be regulatory in nature or based on long-term concessional contracts. Both structures provide visibility over the company’s ability to generate cash flow.

“Most regulators allow utility operators to pass on the rising cost of capital, so rising rates do not have a major impact on long-term valuation of assets. When rates rise, short-term sharemarket investors tend to reduce their utility holdings. As long-term investors RARE views rising rates as an opportunity t buy solid companies with attractive cash flows. We saw this play out in 2016.”

RARE works with Oxford Economics to formulate its views on global economic trends. Currently Oxford is forecasting real global GDP growth of 2.9 per cent for 2017 – up from 2.4 per cent last year – and growth of 3 per cent in 2018.

Oxford Economics head of Asia economics, Louis Kuijs, says the global economy is in a NICE place right now – non-inflationary consistent expansion. “We see a pattern of synchronized global recovery. The numbers look good,” Kuijs says.

“You would normally expect to see inflation start to move at this point but we think it will be less of an issue than we had expected earlier. There is not as much pressure coming from the labour market as you would normally see in a recovery and that is keeping a lid on inflation.”

The chair of RARE’s investment advisory board, David Maywald, says most of RARE’s current exposures are to regulated utilities. “They are less sensitive to changes in the economy and their cash flows are inflation linked. They are a natural hedge,” he says.


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