The foundations of investing in infrastructure
Posted by Fiona Liu in Portfolio management category on 31 Mar 17
As with many aspects of investing the different approaches, strategy and underlying investment process can be complex. We have produced various articles which seek to dismantle the complexity and try to explain the investment universe in simple language.
In this piece, we introduce the concept of infrastructure investment and explore the benefits and risks. In our next piece, we look at infrastructure funds and how you can invest in this area.
What is infrastructure?
Infrastructure usually relates to the physical assets that lay the foundation to make a country, region or community function better e.g. buildings, hospitals and communications etc. Investing into this sector can be direct exposure to the real asset or buying shares in a company that has exposure to infrastructure.
The benefits to infrastructure investments:
The UK inflation rose by 1.8% in January 2017 – the highest it has been since June 2014. According to the Bank of England, it forecasts a rise above 2% as the data starts to take into account the effects of a weaker Pound.
A majority of infrastructure investments are often protected from inflation through regulated entities, contracts or concession agreement. E.g. a toll road company may have negotiated and agreed that they are able to increase toll charges when inflation increases. Therefore, the returns are inflation linked which can benefit investors.
An increased chance for stable income
An infrastructure project can take many years to complete. To safeguard against the long period of time, many companies enter into a long term contract (most likely with a Government) and therefore receive a stable income. In addition it is rare to get a disrupter to the industry as it has a high barrier to entry (capital outlay) and the incumbents usually have the backing of the Government.
Even if there is an economic downturn, people will still have to use roads and mobile phones. Therefore, it can act as a diversifier to equities – as they are more likely to be affected by the economy. In addition, research from Gravis Capital Partners (who manages the VT UK Infrastructure Income Fund) has shown that there is a negative correlation between infrastructure and Gilt yields. Therefore, it can act as an alternative asset class to fixed income and spreads the risk of your portfolio.
Staying away from monetary policy and towards fiscal spending
Governments around the world acknowledge that more should be spent on infrastructure but since the 2008 crisis, economic growth has been sluggish. There are signs that increasingly there will be more of a focus on fiscal spending (as increased infrastructure spending announced in UK and US) in an attempt to boost growth.
However, it is unknown whether the UK or US Government’s balance sheet can support this spend and one of the solutions is to seek a partnership with the private sector. This is known as a public-private partnership (PPP) and Donald Trump has hinted that he will seek funds from the private sector to support his infrastructure spend. As an incentive for private companies to get involved in these projects, the Government will usually allow a reasonable profit or a concession agreement to be signed.
What are the risks investing in Infrastructure funds?
Sub-sectors can have a different risk
Greenfield projects (assets that are in its first stage of construction) will naturally carry more risk than assets that are fully operational and earning revenues. However, once the infrastructure is built, there are sub-sectors that will have different sensitivity to the economic backdrop. For investors, this could affect the income received.
For example, the demand for regulated utilities such as electricity is likely to be resilient to any changes in the economy as people will still need to pay to use an essential service. For an investor, this provides a relatively predictable and stable income. On the other hand, assets such as airports carry a higher risk as it is more economically sensitive. When the economy is weak, it is likely less people will travel abroad and this can affect revenues.
Strong political influence
The impacts of regulation and political policies can slow any infrastructure project. For example, if Trump wants to spend $1 trillion on infrastructure, he needs to get the legislation passed through Congress. Even if it is approved, it is unclear which sub-sectors within infrastructures will benefit.
Relatively new asset class
It is a relative new asset class compared to other asset classes such as equities and bonds so historical data is not as available. However, fund managers tend to view infrastructure as having similar features to Real Assets so they can use those data as point of reference.
Global infrastructure funds provide a geographical, political and regulatory diversification however this means you are also exposed to multiple currency volatility. There may be an option to choose a hedged share class to protect against this.
Although infrastructure spending is frequently mentioned in the media, investment into this sector comes with risk. Most fund managers will sit this asset class between fixed income and equities. The likelihood of defaults on a project is low (especially if it has the backing of a Government) but can be delayed or over budgeted. Investing into this sector should be therefore on a long term view. However, with Government spending gradually turning to infrastructure, it will no doubt provide investment opportunities for the active managers.
Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.