The sensitivity of the value of unlisted infrastructure equity investments to changes in the discount rate is about 10% on average. This article was originally published in the Financial Times in April 2021.
A Partial Inflation Hedge
A return of inflation could unveil a significant risk exposure for investors in infrastructure.
This asset class is often presented as an inflation hedge, suggesting that the revenues of infrastructure companies are indexed on inflation. But this is only the case in some sectors: utilities typically achieve a degree of inflation pass-through in their tariff negotiations with regulators. Likewise, some toll roads or social infrastructure projects do have CPI-linked revenues. But many other infrastructure companies do not. Crucially, equity investors discount future dividends, not future revenues and, all the way at the bottom of the cash flow waterfall, the link between changes in CPI and dividends can easily be lost. Infrastructure investments can only be a partial hedge to inflation risk.
However, inflation expectations typically lead to increase in interest rates, both short term and long-term rates, as is the case today. For numerous investors, it is not so much realized inflation but expected inflation driving the term structure of interest rates that matters and impacts their liabilities.
Inflation or Interest Rate Risk?
Infrastructure investments also have a term structure of cash flows, which have to be discounted using a combination of an equivalent term structure of interest rates to which a risk premium must be added to reflect the uncertainty of these future payments. The fair market value of infrastructure investments is thus perfectly correlated with interest rates. This sensitivity is an essential element to consider when addressing inflation risk and infrastructure investment.
“The fair market value of infrastructure investments is thus perfectly correlated with interest rates.”
This, According to EDHECinfra data, the sensitivity of the value of unlisted infrastructure equity investments to changes in the discount rate is about 10% on average, that is, a 1% increase in the discount rate would reduce the fair value of unlisted infrastructure equity investments by 10%, assuming the same future cash flows. Infrastructure investors are this exposed to inflation risk through interest rate risk, because higher inflation will trigger larger changes in market discount rates than in expected future cash flows.
For example, using EDHECinfra data for a sample of 500+ unlisted infrastructure equity investments in 22 countries in 2020, lower future dividends due to Covid-19 contributed on average to reducing the net asset value of unlisted infrastructure investments by approximately -3.5%, while downward movements in interest rates contributed to increasing valuations by more than +5%. Higher risk market premia further deflated them by as much as -9%. Over the past three years, for the same universe, the cumulative impact of changes in interest rates on fair values is +15%, compared to less than one percent for changes in expected cash flows.
Short-Term Volatility and Long-Term Value
All financial assets create risks of losses. Being a long-term, buy-and-hold investor does not change this reality: future cash flows may be paid over a long period of time but knowing their present market value is necessary to ensure prudent and compliant risk management.
Even if the short-term volatility of infrastructure investments is not a concern for long-term investors, their prudential and fiduciary responsibilities require to conduct impairment tests and to know the liquidation value of their assets, as is the case for any financial assets held in connection with financial liabilities. Long term investment cannot mean blind investment.
This is all the more important for investors who have inflation-indexed liabilities. Infrastructure investments can play a positive role in the hedging of liabilities, the value of which is also marked to market and moves in step with real interest rates. In order to correctly manage liabilities and use assets like infrastructure optimally, investors need to understand the role of interest rate risk in their infrastructure portfolio.
Inflation Risk is Real
Just like buy-and-hold investors in illiquid corporate bonds mark their portfolio to reflect the movement of interest rates, investors in infrastructure are exposed to the same ‘duration’ than bond investors. As a result, they are largely exposed to the inflation risk as well.