A quarter of rising interest rates highlights the role of duration in infrastructure investments.
After a year which tested the resilience of infrastructure investments and their sensitivity to lower dividends in the transport sector because of Covid-19 lock-downs and a higher equity risk premium across all sectors, Q1 2021 is a reminder of the role of interest rate risk in long-term investments that have “bond-like” characteristics.
As a point of reference, treasuries had the worst quarter in many years (-4.3% total return*) and the yield on 10-Year U.S. Treasuries, which started the year at 0.93% stood at c.1.7% at the end of March. Corporate bonds followed a similar trajectory (-3.4%*).
Likewise, private infrastructure debt exhibited higher yields at the end of the quarter than it did three months before. The average yield of the EDHECinfra broadmarket private infrastructure debt index stood at 1.88% on 31 Dec 2020 and at 2.3% on the 31st March, despite the fact that the average credit spread has remained steady at c.150bps. The index, which includes 1,000 instruments across infrastructure corporates and projects, is down -1.38% (Euro total returns) on the quarter but continues to exhibit total returns above 4% on a 3- or 5-year basis. Average modified duration now stands at 5.5 years.
On the equity side, the infra300® was down -1.9% (Euro total returns) on the quarter due to a slightly higher risk premia** and an increase in yield from 8.2% to 8.8% (average across 300 constituents). The transport sector contributed the majority of the decrease, on account of both a long duration and continued Covid-related woes in the airport sector. The 1.45% year-on-year performance of the infra300 is driven by a negative contribution to the index of the transport and natural resources sectors, while all other sectors contribute positively to total returns. The year-on-year income return of the infra300 still stands at 7% while the year-on-year capital return is -5.5% (in Euros).
A comparison between infrastructure projects and corporates further highlights the differences in risk profile between different segments of the infrastructure universe. The expected return (or yield) of infrastructure project equity has increased by 50 basis points on average over the past year, whereas corporates have seen a rise of 80 basis points in their cost of equity. Moreover, corporates are more exposed to changes in the discount rate with a duration (sensitivity to rate changes) of about 2 years higher than project finance equity investments.*** In other words, for each increase in the discount rate of 1 percent, corporates make a NAV loss that is 2 percentage point higher than infrastructure projects. Finally, their income returns are also very different: the 5-year moving average cash yield of projects is now at 9% while corporates have seen their ability to distribute dividends curtailed both by high leverage and Covid-19 and their 5-year average cash yield now stands at 7.5%.
* Morningstar US Government Bond Index and US Core Bond Index
** Estimated market risk premia increased mostly due to a higher term spread in a number of countries. The Term spread is one of the key factors used in the EDHECinfra asset pricing model.
*** In effect corporates have much longer lives than projects and tend to pay a similar share of their revenues or free cash flow as dividends, however, their market discount rate is higher and increasing, leading to significant but decreasing difference in duration.
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