Infrastructure investing is coming into focus as the interest rate cycle moves closer to its peak

What are infrastructure assets?

Infrastructure assets are an essential aspect of life and in one form or another touch most Australians almost every day either directly or indirectly. Infrastructure assets include toll roads, airports, water and sewerage plants, telecommunication towers, energy pipelines and transmission grids.

The construction, maintenance and upgrade of these assets requires hundreds of billions of dollars in investment by either governments or the private sector. In cases where these assets are owned by the private sector, the government usually regulates the maximum returns investors are allowed to earn on the infrastructure assets given the essential nature of the service and the market pricing power of asset owners. This is because they are typically monopoly assets with no competition, which means consumers have no choice of service provider and so are price takers.

This pricing power imbalance is addressed however, by an independent government appointed authority where it is considered that the activities of the asset owner give it the market power to persistently behave in a manner different to that of a competitive market. In these cases, the independent pricing authority must determine a fee structure payable by asset users that is reasonable but is also sufficient to enable the monopoly asset owner to make the asset viable and attractive for both debt providers and equity investors. This is positive for infrastructure asset owners and lenders because it provides certainty around the amount and timing of cash flows.

What makes infrastructure assets attractive?

Infrastructure assets are generally long useful-life, legislated monopoly assets that provide essential services and generate stable and predictable recurrent cash flows. This is because the underlying demand for essential services provided by these monopoly asset owners is also stable, predictable, and recurrent.

Furthermore, infrastructure assets have high capital costs, which is a highly effective barrier to entry. This barrier is in addition to legislative barriers that create the legislated monopoly assets by conferring monopoly rights on the asset owner. These rights often provide for the legislated right to increase user fees by the annual inflation rate. Inflation-protected cash flows that are stable and recurrent are attractive to lenders who are prepared to provide long-term funding at higher leverage ratios than would be available to other commercial borrowers. The higher leverage ratio available to infrastructure asset owners is an attractive feature of infrastructure assets because it supports higher risk-adjusted returns on equity to unitholders.

Investors buying units in infrastructure-based funds can expect a stable income stream given the stable nature of the underlying cash flows from the infrastructure asset. Stable cash flows also support a high payout ratio distribution policy, especially where borrowings are hedged against interest rate risk, because free cash flow can be reliably estimated well into the future.

Infrastructure is an asset class that offers a hedge against economic downturns. This is because of the essential and recurrent nature of the underlying cash flow generated by the infrastructure asset for which there is usually no substitute. Of course, there are exceptions to this such as a pandemic that may restrict travel, resulting in lower patronage of toll ways and airports, for example.

Nevertheless, the long-term performance of infrastructure as an asset class is impressive. The ASX Infrastructure Index has delivered a 10-year annualised Total Return of 9.61 percent. Total Return over shorter time horizons shows some volatility in that the ASX Infrastructure Index annualised 3-year return is 15 percent, while the 1- year return is 6.9 percent.

Looking ahead

Some of the factors driving infrastructure demand are population growth and urbanisation, and more recently climate change, which is requiring investment in renewable sources of energy.

Capital costs and replacement costs of infrastructure are high which is going to require large amounts of capital to fund this asset class, and this means the future level of interest rates are an important investment consideration. Long-term interest rate levels also directly impact infrastructure asset valuations.

Infrastructure should be considered as a long-term asset class that performs during periods of elevated inflation and in times of economic weakness. The current interest rate cycle which is approaching or has more likely already reached its peak, is bringing infrastructure investment into sharper focus for income conscious investors.