Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 103

Implications of low rates for infrastructure

Infrastructure is often seen as an alternative to low risk defensive assets like cash and government fixed income in investors’ portfolios. In discussions with infrastructure investors over the past few months, one recurring discussion topic has been the extremely low level of base or risk free interest rates.

Why does it matter?

Part of the attraction of infrastructure at the moment and the record high prices of recent Australian core infrastructure transactions (and the gnashing of teeth amongst infrastructure investors at the cancellation of the former Newman Government asset sales programme) is that returns to traditional low risk sources of yield are so low.

The chart below shows the long term history of Australian 10 year government bond rates. Current yields of 2.5% are the lowest in the history I have been able to access (since 1969). This implies a zero real return (assuming inflation keeps within the 2-3% target band set by the RBA) before tax and fees. Post tax returns for superannuation investors will be negative, an unappetising prospect.

AA Figures1&2 020415

AA Figures1&2 020415

But will such low real base rates persist or go even lower, and how should portfolios be managed in light of low interest rates?

A long term outlook for interest rates

I am not going to make any short term forecast on bond rates. Current forward interest rate markets are probably as good a guess as anyone’s on what might happen in the short term. And in any case, most infrastructure investors are considering investments that last decades and so decisions don’t turn on the short term path for rates.

The more interesting question is the longer term – what do we think interest rates will do over the next 10 or 20 years? Are the rates a structural shift (and the high real rates enjoyed by investors over the past 20-30 years are actually unusual) or should we expect, once the short term impact of recovering from the GFC and QE work their way out of the system, that markets will return to ‘normal’?

Economic theory suggests that in the long term, growth in the economy should match nominal bond rates. The charts below illustrate these relationships for both Australia and the United States (note the different time scales).

Australian 10 Year Bond Rates versus Nominal GDP GrowthAA Figure3 020415

United States 10 Year Bond Rates versus Nominal GDP GrowthAA Figure4 020415

These charts show the relationship works pretty well – albeit recently both countries have had significantly lower bond rates than nominal GDP growth. In Australia, nominal GDP growth has been running at over 6% for the past decade, which is basically a mining boom/terms of trade story.

If you accept this relationship, future real GDP growth in Australia is likely to be significantly lower than over the past couple of decades. Australia won’t benefit from another mining boom. Population growth will be slower. There won’t be the same benefit from increased female participation in the workforce. The following chart, extracted from a speech by Martin Parkinson last year, gives an interesting decomposition of these effects.

AA Figure5 020415My view is that real GDP growth will be weaker, in the 2%-3% range, rather than the 3%-4% which has been ‘normal’ for Australia over the past few decades. A key risk to this is productivity growth which could easily disappoint.

Adding to this is inflation, which will probably track at 2-3% with a continued reversal of the mining boom terms of trade effect. This suggests a 4%-5% nominal GDP growth rate and by implication bond rate. This would be a real bond rate in the 2%-3% range, significantly higher than rates today.

In the US both growth (probably 1.5%-2.5% real) and inflation (1-2%) will be lower suggesting a lower US 10 year bond rate in the 2%-3% range. And this isn’t that controversial – US bond markets currently have a forward interest rate of around 2.5% from about 2020 onwards. It just takes a while to get there from current zero rates!

It is in Australia where the gap between market views (which has cash rates getting back up to 3% in 2021 and basically tracking in the low 3% range from there) and the outlook for nominal GDP is most stark. To reconcile the two would require either much weaker expectations of economic growth or inflation.

The one factor, which is important, but doesn’t figure in a nominal GDP growth based analysis is the high level of debt across the world at present. Debt, except when invested in productive capacity, is future consumption brought forward. The current debt overhang will be a drag on growth for a substantial period ahead. This, directly or indirectly, will be a cap on sharp rises in interest rates as many parts of the world cannot afford higher interest rates. All this suggests to me that the path for rates might be somewhat lower than a raw analysis of nominal GDP growth would suggest.

What does that mean for infrastructure investors?

Infrastructure is a long duration asset. A material share of the strong performance of infrastructure over the last decade is attributable to declining bond rates. If rates rise over the medium term, then necessarily this will be a drag on the future performance of infrastructure assets from today’s valuations. An exception to this is floating rate infrastructure debt.

Look under the hood. Interest rates have direct and indirect impacts on infrastructure valuations. Much of the focus has been on target equity returns and multiples. However, it is important to recognise that base rates have material impacts through the cash flow impact of debt costs.

While many investors talk of their ‘discipline’ in not reducing target equity returns in light of lower base rates, the reality is that their investment bankers (and managers) forecast the cost of debt service using market implied interest rates. This creates a substantial inconsistency between a static equity hurdle and equity return forecasts that include the benefit of cheap debt service costs.

Be consistent. Whatever your view on base rates is, you should be consistent in terms of forecasts for inflation and, for patronage or economic infrastructure assets, revenue projections. In a world where bond rates remain low it seems highly likely that inflation and economic growth outcomes will be much lower than history. A follow-on question for another day is whether low interest rates ‘justify’ the record earnings multiples for recent Australian core infrastructure transactions.

 

Alexander Austin is Chief Executive Officer of Infradebt, a specialist infrastructure debt fund manager. This article provides general information and does not constitute personal advice.

RELATED ARTICLES

Australian and US house prices remain firm

Australian bond yields and inflation

Infrastructure debt and infrastructure equity

banner

Most viewed in recent weeks

Three steps to planning your spending in retirement

What happens when a superannuation expert sets up his own retirement portfolio using decades of knowledge? He finds he can afford much more investment risk in his portfolio than conventional thinking suggests.

Five stock recoveries not hanging on COVID predictions

The focus on predicting the recovery from the pandemic is the wrong emphasis. Better to identify great companies benefitting from market changes over a three- to five-year horizon with or without COVID.

Peak to peak, which LIC managers performed during COVID?

A comprehensive review of dozens of LICs shows how they performed in the crucial 'peak to peak' of COVID. This 14 months tested the mettle and strategies of a sector often under fire, with many strong results.

Finding sustainable dividend stocks on the ASX

There is a small universe of companies on the ASX which are reliable dividend payers over five years, are fairly valued and are classified as ‘negligible’ or ‘low’ on both ESG risk and carbon risk.

Blink and you missed a seismic shift in these stocks

Blink and it happened. If announcements in this sector were made by a producer of iron ore, gas, copper or some new tech, the news would have been splashed across the front pages. Have we witnessed a major change?

How inflation impacts different types of investments

A comprehensive study of the impact of inflation on returns from different assets over the past 120 years. The high returns in recent years are due to low inflation and falling rates but this ‘sweet spot’ is ending.

Latest Updates

Shares

Platinum’s four guiding investment principles

Buying mispriced stocks is often uncomfortable when companies are outside the spotlight and markets are driven by emotions. And it's inescapable that the price paid ultimately determines the end result.

Interviews

Andrew Lockhart on corporate loans as an income alternative

Loans to corporates were the traditional domain of banks, but as investors look for income alternatives to term deposits, funds have combined hundreds of loans into a single structure to create a diversified investment.

Retirement

10 things I learned in my faux-retirement

Pre-retirees should ‘trial run’ their retirements. All those things you want to do - play golf, time with the family, a hobby, write a book - might not be so appealing in reality, but you might discover other benefits.

Retirement

Achieving a sufficient retirement income portfolio

Retirees require a reliable income stream to replace the wages they received when they were working and should focus on the dollar income generated over time rather than the headline yield percentage.

'Wealth of Experience' podcast and ASA webinar on ETFs v LICs

Peter reveals some top stock picks with an emphasis on long-term assets like Sydney Airport, Graham discusses spending in retirement and valuing assets, the key to Amazon, guest Andrew Lockhart and plenty more.

Strategy

Lucy Turnbull’s three lessons on leadership and successful careers

From promoting women to boost culture to taking opportunities as they arise, Lucy Turnbull AO says markets should not drive decision-making and leaders must live and breathe the company's mission and values.

Economy

Are concerns about inflation inflated?

While REITs and some value stocks are considered 'inflation-sensitive' assets, the data provide little support that they are good inflation hedges, and energy stocks and commodities are too volatile. So what works?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.