Real Assets: Pricing powers
Jennifer Bollen explores claims that infrastructure can offset inflation and asks if infrastructure portfolios can be optimised to protect against inflation
Using infrastructure to offset inflation risk has long been considered a powerful investment strategy but the prospect of further above-target inflation is winning infrastructure even greater popularity.
“[Infrastructure as an inflation hedge] will be an area in the next three or four years that will continue to explode,” says Duncan Hale, global head of infrastructure at professional services firm Towers Watson.
While inflation fears have certainly dampened from the fever pitch they reached when central banks began QE back in 2008-10, institutional investors still need to be wary of their exposure.
Serkan Bahceci, a vice-president and head of infrastructure research in the global real assets group at JP Morgan, says that his firm expects only low-to-moderate inflation. “But there is a case where inflation goes up significantly and its likelihood is not negligible,” he adds. “Investors have to protect themselves because it can be detrimental if they do not.”
Similarly, Jim Barry, CIO of renewable power and infrastructure at BlackRock, notes the lack of any “real immediate concern about the wall of inflation”, but reasons: “For index-linked liability-driven institutional investors, [inflation risk is] still always right at the top of their list.”
Research by asset manager AMP Capital in May showed increasing appetite for alternative asset classes, especially for infrastructure, among institutional investors. Its survey of global institutional investors managing a combined $1.9trn (€1.4trn) showed net growth in allocations to alternative asset classes in the first quarter of 2013 and a third of respondents anticipating an increase in such allocations this year.
Real estate was the biggest asset class named by investors as a candidate for increased allocations, cited by 72% of respondents, with infrastructure in second place with 56% and infrastructure debt in third place with 28%. At the time of the survey, 35% of the investors held less than 5% of their portfolio in real assets.
Infrastructure’s popularity reflects investors’ desire for stability – the research showed that reducing risk was the second-biggest change investors expected to make to their portfolios this year, with 27% of respondents looking to cut risk. Expansion into new asset classes was the biggest structural change respondents expected to make, cited by 32% of investors.
Infrastructure and real estate are often cited as the best asset classes for investors wishing to gain protection against inflation, with both offering capital appreciation in the underlying assets in the long term. In addition, regulation of many infrastructure assets means such businesses can make a fair return by passing total costs to their consumers in line with inflation, providing they deliver a reliable service. Similarly, public-private initiatives offer contracts outlining a revenue stream from government, linked to RPI. David Cooper, executive director of debt investment at Industry Funds Management, cites this as the most direct route to inflation protection in infrastructure.
Figures from JP Morgan appear to support the theory that the asset class performs well in periods of high inflation – between 1972 and 1982 (the OECD’s last period of high inflation), US CPI increased at an average compound annual growth rate of 8.7%. In this time, total returns generated by regulated utilities had a CAGR of 9.8%.
By comparison, in the same period, the S&P 500 index and US investment grade corporate bonds generated CAGRs of 1.8% and 6.8%, respectively. Meanwhile, commodities, also thought to be closely correlated to inflation, returned just 3.2%.
So inflation exposure seems to be there in a diversified infrastructure portfolio. But can investors take that a step further and optimise an infrastructure portfolio for that inflation exposure?
No clear template
Utilities and toll roads are frequently cited by investment managers as some of the best examples of inflation-linked infrastructure assets, the latter because asset owners can simply raise the cost of using a toll road to protect their investment.
Ideally, pension funds should seek explicit inflation linkage – terms that distinctly set out inflation protection, although many investments offer implicit inflation linkage.
Debate surrounding the best way to access inflation linkage in infrastructure – through debt or equity – continues, partly since debt is less risky but, as a result, offers lower returns than equity in the long term.
“If you are looking for explicit, RPI inflation-linked cash flows, that means going down the debt route,” says Conrad Holmboe, a vice-president at investment consultancy Redington.
Investors can get equity exposure through a fund, but as Holmboe observes, these will typically have a lifecycle of seven years or so and, as a long-term investor with liabilities that span several generations, pension schemes would probably want to hold onto their assets for as long as they can.
“The rationale is you have steady, secured, attractive cash flows that can be used to better match your liabilities,” he says. “Alternatively, you could buy the whole project but that may be quite an expensive and undiversified way of getting the exposure.”
Hale says the view that equity typically refers to private equity-style investments is outdated, given the rise of strategies across infrastructure aiming to provide inflation-linked cash flows, using longer-life funds.
Hale adds that accessing inflation-linked infrastructure debt can be difficult due to its popularity, and that many assets with inflation-linked cash flows, such as utilities, are big enough to raise relatively cheap debt in the capital markets. “This means that many pension funds actually have exposure to these assets elsewhere in their portfolio,” says Hale.
The alternative sources of illiquid inflation-linked debt, such as smaller utilities, renewable energy and PFI deals, are limited, he says.
Managers say there is no clear template for an effective inflation-linked infrastructure portfolio since the inflation protection properties within assets vary, making it difficult to outline an optimisation strategy.
“I can have any type of infrastructure asset that has inflation exposure,” says Barry. “You typically tend to get it more in toll roads, some elements of PPP, energy assets will have some element. The vast majority of infrastructure investments will have some inflation exposure, whether it is in the revenue line or in a sector with residual value. But the specifics can vary dramatically from asset to asset, even in the same market in the same sector.”
“It is totally dependent on the framework – the revenue framework the asset operates in, if it is a contractual arrangement or a regulated arrangement,” says Peter Hofbauer, head of infrastructure at Hermes GPE. “We calculate what sort of inflation correlation [we need] and the level of inflation protection [the asset] provides but it is very difficult to generalise because there are a range of contractual arrangements and regulatory structures and overlaying that, the level of correlation is influenced by what capital structure is put in place.”
Then, of course, there is the question of what type of inflation you are trying to protect yourself against – which will vary significantly depending on the liabilities of each investor. While most managers agree that investors should prepare for moderate – as opposed to high – inflation, opinion on geography is split. Some recommend that investors protect themselves against local inflation – UK pension funds should hedge against inflation in the UK, for example. But Bahceci argues that this is unnecessary.
“Inflation rates across high income OECD countries are very highly correlated – with all correlation coefficients above 0.8 for CPI inflation growth rates in the US, UK and Germany,” he says. “The correlations tend to rise through time as central banks typically co-ordinate their actions and increasing international trade volumes keep local prices in check, so it is less important whether a long-term investor targets local, national or global inflation. Protection is the correct way to look at inflation hedging strategies. The purchasing power of the investment should not go down. Focusing too much on correlation can be misleading. Also, relying on analysis based on data from the last 30 years, a timeframe when inflation was not significant, can be misleading as well.”
Cooper says: “You will have investors who are looking for a broad inflation protection but also…. are positive around GDP growth and may look at assets like airports where they may have a combination of RPI growth and economic growth. Most of our investors accept the fact they are rarely going to get a perfect hedge. They are looking for a good correlation but not a perfect correlation with inflation. It is better than no inflation link at all.”
There are some who suggest that no inflation link is precisely what you get from infrastructure, however. KJ Martijn Cremers of the University of Notre Dame, who in July published a paper, sponsored by Deutsche Asset & Wealth Management, examining the returns of real assets, says there is not sufficient data to prove infrastructure is an effective inflation hedge (see article in this section). “I am not aware of research that actually has shown that it works,” he maintains.
And even if you accept the industry’s argument on this, just as you can get negative real yields in over-popular inflation-linked bonds, so the market can destroy the wealth-protection potential of infrastructure assets if they become overcrowded. As Holmboe puts it, there are perhaps some pension schemes “so concerned about getting inflation linkage they are prepared to pay over the odds to get inflation linkage”.
If you avoid that trap you will probably find yourself in possession of a real asset whose value will grow in excess of inflation.
Tailoring a portfolio of those assets to optimise that inflation exposure, or closely match the inflation profile of your liabilities, is a tall order – each one is different, and the chances of getting exactly what you want at exactly the right time are slim. But the asset class remains a valuable part of long-term real-return strategies.