CFA Society Singapore
SINGAPORE (Aug 30): Infrastructure has been in the spotlight in recent years as institutional investors continue to seek yield in a low-interest rate world.
The investment opportunities for this real asset sector are expanding globally due to the demand for sustainable energy and the critical need to build or replace roads, bridges, schools and other facilities vital to healthy local economies.
In fact, the World Economic Forum estimates a US$1 trillion ($1.4 trillion) annual shortfall in global spending on basic infrastructure, while The Boston Consulting Group estimates that governments can fund less than half of the US$35-40 trillion in infrastructure spending required over the next 20 years.
Infrastructure provides distinct advantages over many traditional and alternative asset classes: Robust performance, lower volatility, high correlation with inflation, and low correlation with many other asset classes, all of which can improve overall portfolio risk-adjusted returns.
The asset class can be divided into four categories: Private equity, public equity, private debt and public debt.
Although global and Asian institutions have historically favoured private investments, public investments – including municipal bonds offer exclusive access to certain infrastructure assets and provide liquidity.
Private and public equity infrastructure investing
Infrastructure equity has been a key investment category for Asian institutional investors. These investments typically offer reliable cash flows from long-term contracts and returns that are less sensitive to economic cycles than other investments.
Despite the potential for volatility of total returns, predictable, contractual cash-flow yields can be attractive to institutional investors for asset-liability matching.
Unlike bonds with static yields, equity cash flows can grow with the economy, providing a hedge against inflation. This is because infrastructure equity cash flows represent the higher percentage of total returns relative to many equity investments in other asset classes.
Therefore, infrastructure has typically returned a larger share of the market’s upside than the downside, providing better upside/downside capture ratios than traditional equity investments.
Private equity infrastructure investments, which are defined as investments in unlisted companies or private investments in public companies, generally offers higher yields than those typically available in most other public equity investments. In addition, they tend to provide lower volatility, potential for capital appreciation, and very competitive historical risk-adjusted returns.
A key advantage of this strategy is the ability to customise by selecting specific assets that allow for more influence in governance, which can provide greater control over strategy and offer growth opportunities to match the clients’ needs for yield and risk management.
Opportunities representing core investments, which provide more stable income streams with lower risk relative to more core-plus, value-added opportunities, include contracted renewable energy, liquefied natural gas storage, regulated utilities, and transportation. Core-plus investments, on the other hand, can include telecommunication towers and data centers, which can offer higher yields and growth potential, but with more risk.
One example of a core investment is a privately-operated toll road, I-595 Express LLC, located in southeast Florida used by more than 180,000 vehicles daily. Built through a public-private partnership, the highway includes express lanes that charge tolls, with predictable cash flows to investors specified in a 35-year concession agreement that reduces traffic-level risks.
Public equity investments, on the other hand, are listed on stock exchanges. They are typically characterised by their defensive characteristics, including higher yield and lower beta that have historically captured more of the market’s upside and less of the downside compared to global equities. Investors also benefit from a lower initial capital outlay and greater liquidity, as well as the ability to diversity across regions and sectors (including in developing regions in which an investor may not wish to invest through less liquid securities).
Although institutional investors have traditionally favoured private equity over public equity, listed infrastructure stocks are receiving increased consideration. In fact, access to some assets is available only through public stock exchanges, including certain privatized airports, toll roads and subways in European, Australia, and Asia.
An example is Chinese listed equities that invest in pollution control activities such as waste-to-energy, water purification, and hazardous waste treatment. The company offers high growth potential based on increasing projects awards from China’s government agencies.
Private and public debt infrastructure investing
Private debt has typically offered higher yields than public debt as a tradeoff for limited liquidity. Investors may choose private debt in instances where they seek to customise the yield or match the duration of long-dated liabilities.
Subordinated private debt, such as mezzanine capital which resides in the middle of capital stack between senior debt and equity, can offer higher yield than senior debt, but with higher risk and typically with shorter maturities.
Infrastructure debt can be an attractive investment option due to its higher position in the capital structure and resulting lower risk when compared to equity markets. Another important advantage of infrastructure debt is its very low default rates and loss rates when compared to non-financial corporate debt issues.
In certain sectors, such as renewable energy, there are numerous examples of unique, attractive investment opportunities. Hydroelectric facilities, for example, can have useful lives of up to 100 years. Further, they can offer stable income to investors and remain profitable even in low water-flow years because they tend to be the lowest-cost producers of electricity in the region.
Institutions that seek higher yield and capital appreciation potential, but are sensitive to volatility, may favour hybrid investments such as convertible bonds. These offer yield that can increase with economic growth, and the potential for capital appreciation if the underlying company’s value rises.
For public debt, although investors often think first of corporate bonds and hybrid securities, municipal bonds actually represent the largest infrastructure debt market. In the US, in fact, this sector finances most domestic public infrastructure projects. Infrastructure financed by municipal bonds consists largely of investment-grade quality, fee-generating public projects, such as water and sewer systems.
Municipal bonds are particularly attractive to non-US institutional investors facing near-zero or negative yields on their domestic sovereign debt. Compared to similarly rated corporate bonds, municipal bonds can offer similar yields with more stable credit ratings and much lower default and loss rates.
Asian institutional investors should consider a dedicated allocation to infrastructure investments, based on the asset class’ demonstrated potential to improve many portfolios risk-adjusted returns. Infrastructure has generally low or negative correlations with traditional asset classes, and high correlation with inflation, thus historically providing strong diversification benefits.
Relatively high and predictable income returns have also provided additional diversification not available from other asset classes. Historical analysis using returns for a 14-year period, from 2002 to 2015, showed strong diversification benefits when combined with traditional stock and bond portfolios, including stock and bond portfolios that already have some level of existing exposure to alternative investments such as private real estate.
Although each infrastructure category (public and private equity and debt) showed robust performance, combining multiple infrastructure categories further improved results due to low correlations among the categories themselves. As a result, global markets have responded with heavy demand for infrastructure investments that may compress future returns. Investors can improve their chances of accessing high-value opportunities, however, by selecting managers with specialised expertise and longstanding industry relationships providing access to proprietary deal flow.
John Goodreds is the Head of Alternative Solutions at Nuveen, the investment management business of financial services company TIAA with US$906 billion AUM