Time to revisit infrastructure?

Look out for further promises from the Chancellor on boosting UK infrastructure investment when Jeremy Hunt makes his Autumn Statement later this month. But while Mr Hunt is convinced investors such as pension funds have a bigger role to play in building Britain’s energy, transport, power and communications systems of the future, it’s worth noting that investment companies have been putting money into infrastructure for years. And now may be just the time for advisers to take a closer look at this sector of the investment companies universe.

The promise of infrastructure investment is secure long-term returns – sometimes underwritten by the state – from tangible physical assets, with generous income often on offer. That allure has seen plenty of advisers move client money into infrastructure investment companies in recent years, but performance has struggled of late, leading some to question the asset class.

The good news is that the explanation for these funds’ recent difficulties also provides hope for a recovery. The steep rise in interest rates of the past 18 months has had a direct impact on these funds, both at a portfolio level and in terms of investors’ appetite for them. So now we finally seem to be close to the top of the interest rate cycle – the Bank of England has just kept the cost of borrowing on hold for the second consecutive month – there are reasons for optimism.

Higher interest rates are bad news for infrastructure in two ways. Most obviously, rate rises drive up yields on fixed-income assets, including gilts issued by the UK Government. If investors can get a competitive income from these assets, where there is little risk of capital loss (at least when they are held to duration), they are less inclined to put their money into any asset classes where the potential for volatility is greater.

The second issue is that infrastructure assets are valued by analysing the future cashflows they will generate in today’s terms. Higher interest rates automatically bring those valuations down. A related problem is that many funds borrow in order to invest, so higher interest rates can increase their costs.

These headwinds have seen infrastructure investment companies take a knock – the average fund’s shares currently trade at a discount to the value of its underlying assets of around 20% – three years ago, by contrast, many of these funds were trading on a premium. Share price performance over the past 12 months has largely been negative, though net asset value performance has often been flat.

Still, the negative impacts of interest rates might just be behind us. And we are also starting to see some positive effects come through. In particular, infrastructure assets often pay incomes that are linked to inflation, which has been elevated (hence the need for higher interest rates). That is beginning to help portfolio performance.

Many economists now expect interest rates to come back down in the medium term – maybe not to the rock bottom levels seen in the recent past, which were a historical anomaly, but by at least a couple of percentage points. In which case, the negative effects seen in the infrastructure sector over the past year should be mirrored by positive effects going forward.

This may not be an overnight shift – indeed, there is still some speculation that interest rates could rise a little further before a downwards trend is established. Still, with infrastructure investment companies currently trading on such significant discounts, now is a good time for advisers to take a look.