For some time, investors have been aware that interest rates are at an all-time low. With the Bank of England raising interest rates for the first time in a decade, Peter Hofbauer, Head of Infrastructure, Hermes Investment Management, asks: what impact could rising interest rates have on investors and infrastructure asset values?
At Hermes Infrastructure, we have been focussed on the potential impact of rising interest rates and structured our portfolio over the last five years to ensure it is resilient against future increases in real interest rates. Some of the issues considered and steps we have taken to manage this potential exposure are set out below.
A large number of investors invest in infrastructure to match long-term, often inflation-linked, liabilities. Consequently, a rise in long-term inflation and/or long-term interest rates (and therefore discount rates) can impact liabilities and deficit positions. Expectations of future increases in interest rates are driven by expectations of rises in real yields or inflation, or a combination of both. The relationship between changes in interest rates and inflation, particularly the shape of the interest-rate curve, will be key to how investors are impacted. Additionally, the underlying factors that result in such a rise in real interest rates, such as strong global growth, will be essential in considering the implications of a rise in real interest rates.
When considered in isolation, the effect of higher discount factors resulting from rising interest rates is generally negative on both liability and asset valuations, and in turn often leads to reductions in deficits. We consider the approach of seeking to mitigate potential exposure to rising interest rates only through the application of this macroeconomic assumption to be oversimplified.
Investment and portfolio construction implications
We regard the ability of investments to mitigate against, or take advantage of, interest-rate rises to be a key focus when considering both individual asset selection and portfolio construction. The investment characteristics that we believe will be instrumental in portfolio’s resilience to higher interest rates are:
As part of a robust investment process, the following must be considered:
1. Pricing power
The pricing power of infrastructure businesses needs to be considered when assessing the potential exposure to interest-rate rises. Those businesses that fulfil an essential service and can demand a real price increase as compensation for a real increase in interest rates are well positioned to mitigate any potential margin reduction associated with real interest-rate increases.
2. Capital management
Infrastructure businesses tend to be capital intensive and able to support appropriate levels of third-party debt. Consequently, appropriate capital management, including interest-rate hedging and multiple debt maturities, provides a further tool for infrastructure businesses to mitigate this potential exposure.
Portfolio construction implications
There are three key areas that investors must deliberate when considering potential interest-rate exposure in an infrastructure portfolio:
1. Inflation linkage
We have sought to construct a portfolio of investments that demonstrate a strong linkage to UK inflation to better match our clients’ long-term liabilities. More than 80% of the revenues from assets in our current portfolio are linked to UK inflation.
This linkage largely mitigates any rise in long-term interest rates driven by rising inflation expectations.
Not all investments demonstrate the same risk in respect of interest-rate-duration exposure.
UK-regulated water utilities are good examples of perpetual assets that prima facie demonstrate short interest-rate-duration exposure because their revenues are set by the regulator every five years with reference, in part, to prevailing interest rates.
Concession or depreciating assets, such as Private Finance Initiative concessions or renewable assets that demonstrate an average investment period or duration of less than the investment life, are considered to have lower interest-rate-duration exposure. For instance, a 20-year depreciating solar-power asset may in fact have a 12-year investment duration due to the progressive return on and return of capital over the asset’s full life.
3. Trailing capital structure
Many infrastructure assets with leverage have what may be thought of as trailing interest-rate exposure, resulting from long-dated financing structures.
Further, as a result of the risk profile that infrastructure investors tend to seek, many infrastructure companies that use leverage also use interest-rate-hedging instruments, such as swaps, to effectively fix the interest-rate exposure on their debt. Therefore some companies may have locked in paying much higher rates than those that have prevailed in the market recently, depending on when these swaps were put in place.
As the maturities of these hedging arrangements expire, it is likely that even if interest rates increase further from current levels, companies with such swap arrangements are likely to still experience a reduction in the effective interest rates payable on their debt capital structures.
A final point to consider is the approach adopted for the valuation of infrastructure assets in the current low-interest-rate environment. We obtain independent valuations on a semi-annual basis from qualified professional valuers. These valuations recognise the artificially low-interest-rate environment created by quantitative easing (QE) and have in general incorporated a specific alpha in the discount rate applied to forecast cash flows, thereby normalising the valuation discount rate to levels more reflective of a non-QE interest-rate environment. As such, we would expect this QE specific alpha to be unwound as real interest rates change to reflect a non-QE environment. This will assist in counteracting the effect of increases to the risk-free rates within the valuation discount rate.
Additionally, the cash flow forecasting models used in our valuations have incorporated the view that interest rates will rise in the future. While the forecasts used may not match the actual timing or magnitude of interest-rate rises, we assume that further tightening is probable and that it is prudent to partially mitigate the effects of future real interest-rate increases.