Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 141

Infrastructure risk factors in the current macro environment

Over the past six months, we have seen an environment of lower growth in China, uncertainty in equity markets, continuing downward pressure on the prices of resources, the start of a Federal Reserve (‘Fed’) tightening cycle and signs of a potential high yield credit squeeze and repricing. These are all cause for us to reflect on our approach to risk.

At Magellan, we seek to take a holistic view of infrastructure which considers various risk factors in whether an asset meets our definition of infrastructure and standards for investing. The stability of earnings is determined by more than an asset’s competitive position; there is a range of other risk factors which will influence earnings streams.

We assess many risk factors, but the past few months have highlighted a few worth considering:

  • Sovereign risk: we avoid countries where political decisions can easily be made which undermine the contractual position or potential earnings of a company.
  • Additionally, we only invest in countries where the judicial system and law are sound so that contractual positions can be enforced in need.
  • Regulatory risk: we avoid jurisdictions where regulatory processes are opaque or inconsistently applied.
  • Commodity price risk: we do not invest in businesses which are materially reliant on the price of the product which they transport e.g. many pipeline businesses and Master Limited Partnerships (MLPs) in the United States are excluded from our universe for this reason.
  • Leverage risk: we avoid businesses with high leverage or where their ability to service their debt is tight relative to their earnings.

Interest rates, debt and leverage

We expect global monetary conditions to experience further tightening over the medium term and, consequently, for longer tenor rates to increase.

There are two key areas to focus on when considering interest rates: the impact on the businesses in which we invest, and the impact on valuations and on debt and equity markets.

1. Impact on the businesses in which we invest

We are confident that the underlying businesses in which we invest are in good shape, have strong capital management and are well-placed to manage successfully any inevitable increases in base lending rates. Strong capital management is critical and means these businesses largely have:

  • Solid investment grade credit ratings, which are important to ensure they have access to multiple credit markets at all times regardless of credit cycles.
  • Strong credit metrics i.e. they have a level of leverage that underlying earnings can comfortably support, and have strong debt service ratios. We estimate that, on average, the companies in our investment portfolio generate free cash to service debt of more than four times their annual debt service, which we view as a strong buffer particularly given the stability of the underlying earnings.
  • Access to various debt markets (e.g. US, Europe, Canada, Australia), meaning they are not reliant on any single market.
  • Improved credit ratings over time as their earnings and credit metrics have improved.
  • Available liquidity and credit facilities to fund expansion or liquidity requirements.
  • Lengthened and de-risked their debt maturity profiles so that the average repayment term dates are typically 8 to 10 years out, and repayments of debt in any single year is not excessive relative to the total debt burden.
  • Managed interest rate exposure by undertaking material interest rate hedging or issuing fixed rate bonds to ensure earnings remain stable over the longer term.
  • Reduced the cost of their borrowings throughout 2010 to 2015 by taking advantage of cheaper credit (lower base rates and margins), but also have further opportunity to reduce debt costs over the medium term by replacing more expensive ‘old’ debt which is becoming due for repayment over the next few years.

It is important to note this last point. While interest rates are very likely to increase in the United States in the next few years, the average cost of debt of the US stocks in our funds is likely to continue to fall as maturing debt is replaced with cheaper debt. As an illustration, the following graph shows consensus forecasts for the average cost of debt for Kansas-based power utility, Westar Energy Inc, showing the average cost of debt declining until 2018.

GS Picture1 050216

GS Picture1 050216

So overall, we remain confident that these businesses are well-placed to continue to meet our investment expectations over the medium term and through a period of rising rates.

2. Impact on valuations and on equity markets

An increase in interest rates can be expected to lead to a higher cost of debt and an increase in long term discount rates. Our forecasts and valuations take these factors into account in our investment analysis. However, the history of financial markets leads us to expect increasing uncertainty as a consequence of a rising rate environment.

Stocks which are regarded as ‘defensive’, including infrastructure and utilities, are often subject to negative sentiment during periods of interest rate increases as investors switch to higher growth sectors. However, it is our experience that, provided the businesses have solid fundamentals, their stock prices can be expected to revert to trend reflecting their underlying earnings profiles.

Notwithstanding equity market volatility we expect that underlying earnings of infrastructure and utilities companies in our defined investable universe should continue to be robust and reflect solid growth.

Ultimately the value of the companies in our investment portfolio reflects the future cash flows they are expected to generate and the risks associated with those cash flows. Magellan believes that, at the current time, investment markets are not pricing assets at the prevailing interest rate levels but rather, are pricing in a higher, more ‘normal’ level of interest rates in assessing the risks associated with future cash flows. This means that if interest rates increase over the medium term we can expect the impact on asset prices to be somewhat muted because investors have already allowed for some level of increase.

 

Gerald Stack is Chairman of the Investment Committee and Head of Investments at Magellan Financial Group and Portfolio Manager of the Magellan Infrastructure Fund. He has extensive experience in the management of listed and unlisted debt, equity and hybrid assets on a global basis.

This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.


 

Leave a Comment:

     

RELATED ARTICLES

8 benefits of listed over unlisted infrastructure

Summer Series Guest Editor, Greg Paramor AO

Why infrastructure stocks can withstand higher interest rates

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Strategy

$1 billion and counting: how consultants maximise fees

Despite cutbacks in public service staff, we are spending over a billion dollars a year with five consulting firms. There is little public scrutiny on the value for money. How do consultants decide what to charge?

Investment strategies

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Financial planning

Reducing the $5,300 upfront cost of financial advice

Many financial advisers have left the industry because it costs more to produce advice than is charged as an up-front fee. Advisers are valued by those who use them while the unadvised don’t see the need to pay.

Strategy

Many people misunderstand what life expectancy means

Life expectancy numbers are often interpreted as the likely maximum age of a person but that is incorrect. Here are three reasons why the odds are in favor of people outliving life expectancy estimates.

Investment strategies

Slowing global trade not the threat investors fear

Investors ask whether global supply chains were stretched too far and too complex, and following COVID, is globalisation dead? New research suggests the impact on investment returns will not be as great as feared.

Investment strategies

Wealth doesn’t equal wisdom for 'sophisticated' investors

'Sophisticated' investors can be offered securities without the usual disclosure requirements given to everyday investors, but far more people now qualify than was ever intended. Many are far from sophisticated.

Investment strategies

Is the golden era for active fund managers ending?

Most active fund managers are the beneficiaries of a confluence of favourable events. As future strong returns look challenging, passive is rising and new investors do their own thing, a golden age may be closing.

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.