Infrastructure offers attractive yield-based returns
AMP Capital strategist Shane Oliver says the asset class provides a low correlation to shares and bonds.
With equities having had a great run and bond yields being very low, infrastructure is likely to be attractive for investors seeking to diversify their portfolios, says Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors.
"Infrastructure is a growing area of interest for investors," says Sydney-based Oliver. "Not only does it offer attractive yields and solid return potential, it's also a good diversifier."
Infrastructure, after all, has had a low correlation to shares and bonds, he says.
Oliver refers to the broad definition of infrastructure when recommending this asset class to investors. It refers to assets used to satisfy general community, social and economic needs. These include utilities (electricity generation, transmission and distribution, gas distribution and water), transport infrastructure (toll roads, rail, airports, ports, ferries) and social infrastructure (such as prisons, public housing and hospitals).
Infrastructure investments typically have high upfront capital commitments, low operating costs and relatively predictable cash flows and operational risks. The predictability of cash flows is present because consumer demand for their services is usually stable. Since infrastructure assets provide basic needs, demand for such assets generally remain stable. Gas and electricity usage, for example, tends to grow steadily even during economic downturns.
Growth in infrastructure tariffs is often regulated to link to the rate of inflation, huge capital requirements provide barriers to entry, operating costs are usually low and payment or credit risk is low. Thus, infrastructure offers a relatively high income yield contribution to total return. Income yields on unlisted infrastructure investments are typically around 5-10%, Oliver says.
A risk to infrastructure investments is a sharp rise in interest rates given that the relatively steady cash flows they generate has allowed them to run high gearing levels, Oliver says. "This is one factor investors must keep an eye on."
Going forward, infrastructure returns are likely to be less than they have been in recent years, however. "As investor demand has been strong, infrastructure assets are being acquired on more expensive valuations," he says.
There are various ways of investing in infrastructure.
One way is though unlisted infrastructure funds. These are a bit like unlisted property funds and invest in a range of infrastructure assets or projects. These tend to offer an absolute return target of around 9% annually, which sometimes might be expressed as the bond yield plus a margin of around 3%, Oliver says. The downsides include the relatively low liquidity, long pay-back periods of many projects, and the dependence on the fund manager to get exposure to assets (often by bidding for large public assets or projects). Several fund managers offer unlisted infrastructure funds, but usually only to institutional investors, and they have increasingly been going global reflecting a lack of local opportunities.
Another way is investing directly in listed infrastructure shares. Oliver notes that infrastructure and utility stocks now account for 5% of global share markets.
Another way is through listed infrastructure funds. These are now offered by a large range of fund managers and invest in a portfolio of listed infrastructure shares and provide easier access to infrastructure investments, liquidity and greater diversification because they can be exposed to a broader range of infrastructure assets than unlisted funds. On the downside, they come with higher volatility and have a higher correlation to shares. Comparing listed and unlisted infrastructure is a bit like comparing listed and unlisted property.
Another way is through enhanced yield or debt-based funds. These include investments in infrastructure debt, such as debt issued by electricity distributors) - but this is usually along with investments in corporate debt. This will have the characteristics of debt investments, and will therefore appeal to a specific risk profile.
In Australia, where Oliver is based, budgetary pressures have seen public capital spending fall relative to gross domestic products since the 1970s. He notes it is doubtful that private sector investment in privatised assets has made up for the decline.
"The lack of investment in infrastructure is reflected in problems with transport infrastructure, water supply and occasional electricity shortages,ö he says. "It has been a major factor in preventing the mining sector from taking full advantage of the resources boom - just look at the ships lined up off Newcastle harbour."
However, while there is strong demand for infrastructure investments from private sector investors, there has been a log-jam in the supply of these projects where the trend to privatisation has slowed, Oliver notes. "This has resulted in the odd situation where even though there is a deficiency of infrastructure in Australia, the demand for infrastructure investments has exceeded its supply."
The average exposure of Australian superannuation funds to infrastructure is around 2%, but this masks a wide range from zero to 8%, Oliver says. "Our analysis indicates that a balanced investment portfolio could justify up to 10% exposure in infrastructure depending on the allocation to unlisted property. The ideal allocation tends to rise as the risk profile of a diversified portfolio increases."
One way to overcome the lack of liquidity associated with unlisted infrastructure is to consider a mix of listed and unlisted infrastructure, Oliver says. "The infrastructure allocation should arguably come from a combination of bonds and equities."
In the case of bonds, it is notable that infrastructure, like property, shares similar characteristics in terms of a high yield and low correlation to shares.
"So with bond yields being low, there is clearly a case to consider infrastructure as an alternative, he says.öBut this shouldn't be taken too an extreme, given government bonds are far safer than infrastructure."
"Infrastructure is a growing area of interest for investors," says Sydney-based Oliver. "Not only does it offer attractive yields and solid return potential, it's also a good diversifier."
Infrastructure, after all, has had a low correlation to shares and bonds, he says.
Oliver refers to the broad definition of infrastructure when recommending this asset class to investors. It refers to assets used to satisfy general community, social and economic needs. These include utilities (electricity generation, transmission and distribution, gas distribution and water), transport infrastructure (toll roads, rail, airports, ports, ferries) and social infrastructure (such as prisons, public housing and hospitals).
Infrastructure investments typically have high upfront capital commitments, low operating costs and relatively predictable cash flows and operational risks. The predictability of cash flows is present because consumer demand for their services is usually stable. Since infrastructure assets provide basic needs, demand for such assets generally remain stable. Gas and electricity usage, for example, tends to grow steadily even during economic downturns.
Growth in infrastructure tariffs is often regulated to link to the rate of inflation, huge capital requirements provide barriers to entry, operating costs are usually low and payment or credit risk is low. Thus, infrastructure offers a relatively high income yield contribution to total return. Income yields on unlisted infrastructure investments are typically around 5-10%, Oliver says.
A risk to infrastructure investments is a sharp rise in interest rates given that the relatively steady cash flows they generate has allowed them to run high gearing levels, Oliver says. "This is one factor investors must keep an eye on."
Going forward, infrastructure returns are likely to be less than they have been in recent years, however. "As investor demand has been strong, infrastructure assets are being acquired on more expensive valuations," he says.
There are various ways of investing in infrastructure.
One way is though unlisted infrastructure funds. These are a bit like unlisted property funds and invest in a range of infrastructure assets or projects. These tend to offer an absolute return target of around 9% annually, which sometimes might be expressed as the bond yield plus a margin of around 3%, Oliver says. The downsides include the relatively low liquidity, long pay-back periods of many projects, and the dependence on the fund manager to get exposure to assets (often by bidding for large public assets or projects). Several fund managers offer unlisted infrastructure funds, but usually only to institutional investors, and they have increasingly been going global reflecting a lack of local opportunities.
Another way is investing directly in listed infrastructure shares. Oliver notes that infrastructure and utility stocks now account for 5% of global share markets.
Another way is through listed infrastructure funds. These are now offered by a large range of fund managers and invest in a portfolio of listed infrastructure shares and provide easier access to infrastructure investments, liquidity and greater diversification because they can be exposed to a broader range of infrastructure assets than unlisted funds. On the downside, they come with higher volatility and have a higher correlation to shares. Comparing listed and unlisted infrastructure is a bit like comparing listed and unlisted property.
Another way is through enhanced yield or debt-based funds. These include investments in infrastructure debt, such as debt issued by electricity distributors) - but this is usually along with investments in corporate debt. This will have the characteristics of debt investments, and will therefore appeal to a specific risk profile.
In Australia, where Oliver is based, budgetary pressures have seen public capital spending fall relative to gross domestic products since the 1970s. He notes it is doubtful that private sector investment in privatised assets has made up for the decline.
"The lack of investment in infrastructure is reflected in problems with transport infrastructure, water supply and occasional electricity shortages,ö he says. "It has been a major factor in preventing the mining sector from taking full advantage of the resources boom - just look at the ships lined up off Newcastle harbour."
However, while there is strong demand for infrastructure investments from private sector investors, there has been a log-jam in the supply of these projects where the trend to privatisation has slowed, Oliver notes. "This has resulted in the odd situation where even though there is a deficiency of infrastructure in Australia, the demand for infrastructure investments has exceeded its supply."
The average exposure of Australian superannuation funds to infrastructure is around 2%, but this masks a wide range from zero to 8%, Oliver says. "Our analysis indicates that a balanced investment portfolio could justify up to 10% exposure in infrastructure depending on the allocation to unlisted property. The ideal allocation tends to rise as the risk profile of a diversified portfolio increases."
One way to overcome the lack of liquidity associated with unlisted infrastructure is to consider a mix of listed and unlisted infrastructure, Oliver says. "The infrastructure allocation should arguably come from a combination of bonds and equities."
In the case of bonds, it is notable that infrastructure, like property, shares similar characteristics in terms of a high yield and low correlation to shares.
"So with bond yields being low, there is clearly a case to consider infrastructure as an alternative, he says.öBut this shouldn't be taken too an extreme, given government bonds are far safer than infrastructure."
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