The elephant in the room: Rising interest rates will test infrastructure investment performance
Investors - SEPTEMBER 13, 2018

The elephant in the room: Rising interest rates will test infrastructure investment performance

by Drew Campbell

At IREI’s VIP Infrastructure conference in June, we polled attendees, asking what keeps them up at night, or, in other words, what do they view as the biggest risks to their infrastructure portfolios going forward. The answers with the most responses were high asset prices (58 percent) and political and regulatory risk (29 percent). Rising interest rates (4 percent) received the fewest responses.

Several people commented during the event that they were surprised there was not more discussion of interest rates and their effect on portfolio and asset values. But perhaps some of the concern over interest rates was indeed reflected in the high number of VIP Infrastructure participants selecting asset prices as their top concern. Infrastructure investments are financed with a substantial amount of debt — about 75 percent on average — and rates affect the costs and prices paid for infrastructure investments.

Regardless of the survey answers and the reasons behind them, central banks have raised interest rates from historic lows and are signaling future increases. As it becomes more expensive to finance investments with debt, the cost of infrastructure investments also increases, leaving investors with the strongest balance sheets in the best position to win investments while others move to the sidelines.

With reduced competition, prices could follow a similar path downward, or at least stop rising.

Then what? If you invested at these high valuations using floating rate debt, can you service that debt as rates and payments increase? If valuations decline, does your debt-to-equity ratio leave you with fewer financing options? And if you haven’t refinanced into longer term debt by now, is your window of opportunity closing?

Regulators raise interest rates to keep growth and inflation in check, and the recent increases could be an attempt to “tap the breaks,” but that maneuver, as the past two decades shows, can eventually contribute to market corrections or even crashes.

Accompanying historic-low interest rates, not surprisingly, has been an expansion of debt on public and private balance sheets — why turn down cheap money?

It seems hindsight not only isn’t 20-20, but it also is short sighted. Have markets forgotten the frenzy leading up to the U.S. crash in 2008? Or maybe investors are confident the regulations put in place post–Great Financial Crisis can contain a repeat performance? But with Republicans in control of the House of Representatives, the Senate and Presidency, and Republican-appointed judges filling court vacancies, regulations of all kinds are set to be rolled back.

Against this backdrop, some market watchers warn that corporate debt could be the fuse to ignite the next market crash. Others point to debt-burdened governments.

Similar to the 2008 crash, any culprits would only be known after the dust settles. Until then, it’s not a bad idea to understand how we got here and where we could be going. Below are five reports and papers that review interest rates, inflation and debt and how they interact with infrastructure investing.

McKinsey & Co. explores corporate and government debt in two recent reports, Visualizing global debt and A decade after the global financial crisis: what has (and hasn’t) changed? noting, “An extended period of historically low interest rates has enabled companies around the world to take on cheap debt. Global nonfinancial corporate debt, including bonds and loans, has more than doubled over the past decade to hit $66 trillion in mid-2017. This nearly matches the increase in government debt over the same period.”

Bloomberg News reporter Brian Chappatta explores the “great unwind” set in motion by global central banks after a decade of low interest rates in $250 Trillion in Debt: the World’s Post-Lehman Legacy. “How can officials from the Federal Reserve to the Bank of Japan even pretend to know how to reverse what they’ve done over the past decade?” Chappatta asks. “I’m speaking specifically about propping up financial markets with easy money and allowing the world’s debt burden to balloon to almost $250 trillion.”

Analysis by QIC finds the effects of rising interest rates on infrastructure investments are not universal across all sectors. In its red paper, The impact of higher interest rates on infrastructure: nuanced, not black and white, QIC explores macroeconomic and demographic trends globally, including their interplay with interest rates and their combined impact on infrastructure investments, noting, “Rising interest rates don’t necessarily signal negative impacts for all infrastructure assets; the effects on investment performance are derived from changes to future cashflows or to discount rates; and the impact on infrastructure cashflows will depend on the impact on debt servicing and revenue, and could range from highly positive to highly negative.”

UBS recommends infrastructure investors take a nuanced view about rising interest rates and their effects on investments in its report Infrastructure and the economy. “The impact of rising interest rates will ultimately depend on the capital structure of the investment, for example, the floating-fixed ratio of its debt and the level of exposure to refinancing risk,” UBS notes. “As rates have been at record lows for a prolonged period, many infrastructure owners have already put in place long-term financings to lock in lower rates. This should help mitigate the performance impact of the infrastructure sector from rising rates.”

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