GLOBAL LISTED INFRASTRUCTURE: NOT JUST A BOND PROXY This research paper will explore the often misunderstood impact of interest rates on Global Listed Infrastructure and differentiate between the short term impact on equity prices from the long term impact on underlying cash flows and valuation. February 2017 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 1
The paper will focus on the absolute performance of Global Listed Infrastructure and its relative performance to other asset classes during periods of rising interest rates, the impact of rising rates in the context of the asset class diversification and how the drivers of different interest rate components impact Global Listed Infrastructure and its sub-sectors. The analysis is based on our knowledge of the Global Listed Infrastructure companies we analyse and invest in and incorporates previous work undertaken by the AMP Capital s Global Fixed Income team on the global economic outlook. This is a timely and relevant topic, given the performance of the asset class in the context of the recent increase in global sovereign yields, which has once again become a significant focus for investors. Key takeaways >> Financial markets usually overreact to increase in sovereign yields, as implied by short term price performance of Global Listed Infrastructure securities >> The impact of rising yields should be taken into the context of Global Listed Infrastructure s diversification >> Differentiating between nominal and real yields is crucial to understand the impact of interest rates on Global Listed Infrastructure s cash flow and valuation 2 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE
The key theoretical components of infrastructure s sensitivity to interest rates are: > > The nature of the evolution and duration of the underlying cash flows (upfront capital expenditures, followed by a long term steady stream of revenue). This characteristic makes Net Present Value and Equity IRR the most appropriate valuation tools for the asset class; such valuation tools are relatively sensitive to changes in the interest rate assumptions used for discounting future cash flow streams. > > The regulatory frameworks, and sometimes contracts, which are based on the rates of return that these assets are allowed to earn. Sovereign risk free rates are often the foundation of the building block approach to determine allowed rates of return. > > The higher visibility of cash flow as infrastructure assets can usually maintain a higher level of financial leverage. As a result, changes in interest rates can have an impact on financing cost, and ultimately on the cash flow streams themselves. Whilst the impact of these factors on underlying cash flows of infrastructure assets are the same, whether in a listed or unlisted structure, the short term performance of Listed Infrastructure tends to be more greatly impacted by the evolution of interest rates. Indeed, volatility and/or increases in the sovereign bond markets (and yields) have an immediate effect on listed markets, although our analysis suggests equity markets usually overreact to these periods of higher volatility. GLOBAL LISTED INFRASTRUCTURE VS. SOVEREIGN YIELDS Financial markets perspective Sovereign yields began their upward trend shortly after the outcome of the UK s Brexit referendum (June 2016), as higher inflation expectations started to be discounted in breakeven rates, particularly in the UK, but also to a lesser extent in the US, Europe and Asia. Leaving aside FX-specific reasons (i.e. weakness of GBP for UK breakeven rates), the recovery in commodity prices after the 2015 rout was the key driver for improved inflation expectations (Chart 1). However, the success of Donald Trump at the US election in November 2016 has been the catalyst for the recent surge of US sovereign yields, as market participants began to focus on the implications of his pro-growth policies aimed at boosting the US economy and their likely impact on growth and inflation. The increase in US nominal rates spurred a similar increase in sovereign yields globally (Chart 2). Chart 1. US nominal vs. real yields 3.5 3.0 2.5 2.0 1.5 1.0 0.5 Chart 2. Global nominal yields 4.0 3.0 2.0 1.0 0.0 0.0-0.5 Dec-15 Jan-16 Nov-16 Oct-16 Sep-16 Aug-16 Jul-16 Jun-16 May-16 Apr-16 Mar-16 Feb-16 Nominal yield Breakeven inflation Real yield Dec-16-1.0 Dec-15 Jan-16 Oct-16 Sep-16 Aug-16 Jul-16 Jun-16 May-16 Apr-16 Mar-16 Feb-16 US UK Germany France Italy Australia Canada Japan Nov-16 Dec-16 Source: Bloomberg, December 2016 Source: Bloomberg, December 2016 The impact of rising yields should also be taken into the context of the asset class sector diversification. As characteristics like duration, regulatory frameworks and exposure to growth differ from industry to industry and from region to region, not all Listed Infrastructure companies are affected by changes in interest rates in the same way. AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 3
This rise in global sovereign yields has been meaningful, particularly in the US, with the 10-year yield moving from c. 1.4% to c. 2.6%. This sizable increase in interest rates, created a market environment that resulted in Global Listed Infrastructure recording negative performance, both on an absolute basis (c. -4%) and relative to global equities (c. -12%) (Chart 3 & 4). November 2016 was the asset class worst monthly relative performance to Global Equities since 2002 (Chart 5). Chart 3. Global Listed Infrastructure vs. Global Equities and US 10-year yield Chart 4. Global Listed Infrastructure vs. Global Equities and Global Bonds 110 1.0 105 1.5 % 7.5 5.0 2.5 100 2.0 0.0 95 2.5 90 3.0-2.5-5.0 Global Equities (LHS) Dec-16 Dec-16 Nov-16 Nov-16 Oct-16 Oct-16 Sep-16 Sep-16 Aug-16 Aug-16 Jul-16 Jul-16 Jun-16 Global Listed Infrastructure (LHS) -7.5 September '16 - December '16 Global Listed Infrastructure June '16 - December '16 Global Equities US 10 year yield (RHS) Source: Dow Jones, Bloomberg, December 2016 4 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE Source: Dow Jones, Barclays, Bloomberg, December 2016 Global Bonds
Chart 5. Global Listed Infrastructure relative performance 2002-2016 7.5% 5.0% 2.5% 0.0% -2.5% -5.0% -7.5% November 16 performance: -5.7% Monthly performance Average "+2 st dev" "-2 st dev" Source: Dow Jones, Bloomberg, December 2016 As shown in Chart 6, this is not the first time sovereign yields have increased in the last few years. Since the end of the Global Financial Crisis, which marks the beginning of the current business cycle, we have witnessed 4 distinct periods of sizeable and protracted increases (at least 75 bps lasting for more than 100 days) of long term interest rates: > > October 2010 to February 2011. Announcement of QE2, when the financial markets started to price real yields and inflation expectations higher in response to aggressive monetary easing from the Federal Reserve. > > May 2013 to December 2013. Taper tantrum, when the Chairman of the Federal Reserve, Ben Bernanke, announced the Central Bank was looking at tapering the asset purchase program at some point in the future, thus causing real yields to move higher. > > January 2015 to June 2015. Bund tantrum, due to a more technical sell-off as heavy sovereign bond supply hit a relatively crowded positioning following the first few months of the ECB asset purchases program. > > July 2016 to December 2016. Global reflation, which started as a technical sell off in a very crowded market with low bond volatility and gained steam following rapid improvement in global economic data and Mr Trump s election. Chart 6. US nominal yield 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Dec-16 Sep-16 Jun-16 Mar-16 Dec-15 Sep-15 Jun-15 Mar-15 Dec-14 Sep-14 Jun-14 Mar-14 Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Mar-11 Dec-10 Sep-10 Jun-10 Mar-10 Dec-09 Source: AMP Capital, Dow Jones, Barclays, Bloomberg, December 2016 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 5
As shown by Table 1, each of these periods exhibited similar dynamics, with increasing nominal and real sovereign yields (albeit to varying degrees), strong performance of Global Equities, and relative underperformance of Global Listed Infrastructure. However, it is important to highlight Global Listed Infrastructure has recovered all the relative underperformance to Global Equities in the 12 months following these periods of increase in nominal yields (Table 2). Table 1. Absolute performance during periods of rising yields NO. OF DAYS NOMINAL YIELD INCREASE REAL YIELD INCREASE GLOBAL LISTED INFRASTRUCTURE GLOBAL EQUITIES GLOBAL BONDS OCTOBER 10 FEBRUARY 11 124 1.4% 0.9% 5.9% 12.2% -3.2% MAY 13 DECEMBER 13 243 1.4% 1.4% 3.3% 14.5% -1.8% JANUARY 15 JUNE 15 131 0.8% 0.6% -1.6% 6.9% -3.1% JULY 16 DECEMBER 16 162 1.2% 0.8% -4.0% 7.7% -8.2% AVERAGE 165 1.2% 0.9% 0.9% 10.3% -4.1% Table 2. Relative performance following periods of rising yields Global Listed Infrastructure vs. Global Equities OCTOBER 10 FEBRUARY 11 MAY 13 DECEMBER 13 JANUARY 15 JUNE 15 AVERAGE 3-MONTHS 5.2% 3.8% 4.5% 4.5% 6-MONTHS 10.3% 10.2% -7.3% 4.4% 12-MONTHS 16.1% 11.4% 2.6% 10.0% We believe that one of the key reasons behind this absolute and relative recovery in performance, besides a normalisation of interest rates, is the recognition of the asset class long term stability of cash flows. Indeed, it is important to differentiate between the short term volatility of equity prices and the long term stability of cash flows, which, in our view, explains the strong correlation between the long term performance of the asset class and its cash flow growth; this supports our view that Global Listed Infrastructure s investors should always focus on the underlying assets and their ability to generate visible and growing cash flows (Chart 7). Chart 7. Global Listed Infrastructure EBITDA vs. total return 350 300 250 200 150 100 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 Total return EBITDA Source: AMP Capital, Dow Jones, Bloomberg, December 2016 6 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE
GLOBAL LISTED INFRASTRUCTURE VS. SOVEREIGN YIELDS Sector diversification Global Listed Infrastructure is a globally diversified asset class, with exposure to a wide range of sectors across the main regions of the globe (Chart 8). The drivers of cash flows of a communication tower company in Italy are very different to an electric utility company in the US or an airport in Australia. Regulatory frameworks and contracts structures vary greatly from sector to sector and from region to region, as they are based on and exposed to macro variables in different ways. We believe that such diversification is one of the most attractive characteristics of the asset class as it represents a mitigating factor, over the long term, for particular risks arising from micro and macro variables, including changes in interest rates. Chart 8. AMPCI Global Listed Infrastructure investment universe 1,500 1,250 1,000 750 500 250 0 Europe North America Communication Asia Pac Und. Asia Pac Dev. UK Latin America Oil & Gas Storage and Transportation Transportation Middle East Utilities Source: AMP Capital, December 2016 We believe that such diversification is one of the most attractive characteristics of the asset class as it represents a mitigating factor, over the long term, for particular risks arising from micro and macro variables, including changes in interest rates. AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 7
Interest rate, represented primarily by the sovereign long term yield (i.e. the risk free rate ), is one of most important macro variable investors in infrastructure are exposed to, whether in a listed or unlisted structure. This makes it incredibly important for its impact on the asset class to be carefully understood. The biggest driver of infrastructure s sensitivity to changes in interest rates, both on cash flow and valuation, is from the duration of the assets themselves, with factors such as regulation, financial leverage and growth, both economic and stock/sector specific, also having an impact: >> Transportation companies generally have the lowest sensitivity to changes in interest rates, given their exposure to economic growth. Having said that, interest rates tend to impact the sector in different magnitudes because of the assets diverse regulatory frameworks, concessions length and financial leverage. >> Utilities are perhaps the companies with the highest sensitivity to changes in interest rates, given their long duration, above average financial leverage, highly regulated activities with very limited exposure (if any) to economic growth; regulatory framework, company and/or industry specific growth thematic could represent a mitigating factor. >> Communication infrastructure companies also have a relatively long duration and above average financial leverage, which makes them highly sensitive to changes in interest rates. However, the exposure to a secular growth thematic (i.e. mobile data traffic), escalators at or above CPI levels will partially offset the impact from rising rates. >> The Oil & Gas Storage and transportation sector s sensitivity to changes in interest rates is also relatively low. The long duration of asset lives and above average financial leverage are somewhat offset by higher exposure to economic growth and, more importantly, region and/or sector specific growth dynamics, which tend be more sensitive to changes in commodity prices. Given these unique drivers, the sector has a relatively low correlation with the broader asset class. Given the different duration, regulatory frameworks and exposure to growth, it is not surprising that Global Listed Infrastructure s sectors performance have seen meaningful divergence during the aforementioned periods of rising sovereign yields (Chart 9). Chart 9. AMPCI Global Listed Infrastructure investment universe 20% 15% 10% 5% 0% -5% October 10 February 11 May 13 December 13 Utilities Communications Source: AMP Capital, Dow Jones, Bloomberg, December 2016 8 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE January 15 June 15 July 16 December 16 Transportation Oil & Gas Storage and Transportation Average
GLOBAL LISTED INFRASTRUCTURE VS. NOMINAL AND REAL YIELDS Scenario analysis Recognising the differences in characteristics such as duration, regulatory frameworks and contracts structures across the various sectors of the asset class is important to understand the implications/impacts of not only the changes in interest rates, but also the changes in the different components of interest rates (i.e. real rates and inflation expectations). Bond yields are made up of two components; real yield and inflation expectations thus lower bond yields do not necessarily mean lower real yields, particularly when yields approach their lower nominal bound (Chart 10). With unconventional monetary policy having continued to push the boundaries of what can be considered normal, sovereign bond yields have shifted from low to zero to negative in the largest developed economies in the world. As we transition to a different economic and financial environment and given the recent volatility in global bond markets, we believe it is relevant to address the impact of different nominal and real interest rates scenarios on Global Listed Infrastructure and its sub-sectors, in order to provide a framework for portfolio construction and asset allocation. Chart 10. US nominal vs. real yields 5.0 4.0 3.0 2.0 1.0 0.0-1.0 Dec-16 Sep-16 Jun-16 Mar-16 Dec-15 Sep-15 Jun-15 Mar-15 Dec-14 Sep-14 Jun-14 Mar-14 Dec-13 Sep-13 Jun-13 Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 Mar-11 Dec-10 Sep-10 Jun-10 Mar-10 Dec-09 Sep-09 Jun-09 Nominal yield Breakeven inflation Real yield Source: Bloomberg, December 2016 As shown by the chart above, inflation expectations can become relatively unstable, and are particularly vulnerable to factors such as shocks to commodity markets or lack of policy flexibility, in this backdrop of lower sovereign yields. As a result, the historical relationship between nominal bond yields and other asset classes needs to be reassessed and may no longer be valid. This is particularly true for a long duration asset class such as Global Listed Infrastructure, given the relevance of inflation expectations and real yields for both cash flows and valuation. As we transition to a different economic and financial environment and given the recent volatility in global bond markets, we believe it is relevant to address the impact of different nominal and real interest rates scenarios on Global Listed Infrastructure and its sub-sectors, in order to provide a framework for portfolio construction and asset allocation. AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 9
To provide a framework to allow us to better understand the impact on the cash flows and valuation (and share price performance) of the asset class under different interest rates environments, we have referred to the analysis conducted by AMP Capital s Global Fixed Income team in their research paper Call for a new framework and the three hypothetical regimes they identified: > > Diminishing inflation expectations > > Reflation > > Normalisation For all 3 regimes, we have then conducted quantitative and qualitative analysis to estimate how Global Listed Infrastructure s cash flow and valuation will be impacted and the likely effect on each sectors share price performance. This analysis has been undertaken based on our bottom up research and detailed modelling of the infrastructure companies. As part of this approach, and based off the team s depth of knowledge of the underlying assets economic and financial drivers, regulatory frameworks and contract and concession terms, sensitivity analysis has been employed to understand the impact of changes in interest rates and other macro drivers on the cash flows of our companies. Finally we used risk tools to assess historic share price performance in the context of different macroeconomic variables for each of the three potential regimes. Diminishing inflation expectations A diminishing inflation expectations scenario reflects an environment with nominal yields approaching the zero-bound, thus pushing real yields higher (1st movement); this could be the result of Central Banks inability to maintain stable inflations expectations. As more policy options are exhausted, the ability to further influence the cycle declines and the outlook becomes increasingly uncertain. Table 3. Diminishing inflation expectations scenario Impact on Global Listed Infrastructure DIMINISHING INFLATION EXPECTATIONS FIRST MOVEMENT IMPACT SOVEREIGN YIELDS COMPONENTS Breakeven inflation - ー Nominal yields =/- Real yields + VALUATION/PRICE PERFORMANCE Global Equities - Global listed Infrastructure =/- o.w. Communication =/+ o.w. Oil & Gas Storage and Transportation - o.w. Transportation - o.w. Utilities + Source: AMP Capital, Dow Jones, Bloomberg, December 2016 In this environment, as growth is deteriorating, we would expect Global Equities to underperform Global Listed Infrastructure. Within our asset class, we would expect sectors with longer duration and lower sensitivity to economic growth (i.e. Utilities and Communication) to relatively outperform. 10 AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE
Reflation A reflation scenario reflects an environment in which inflation expectations increase following the introduction of highly inflationary growth-stimulating fiscal policy (1st movement); this could result in Central Banks eventually being forced to tighten monetary policy on fears inflation expectations could become unanchored (2nd movement). Table 4. Reflation scenario Impact on Global Listed Infrastructure REFLATION FIRST MOVEMENT SECOND MOVEMENT IMPACT SOVEREIGN YIELDS COMPONENTS ー Breakeven inflation + =/+ Nominal yields = + Real yields - + VALUATION/PRICE PERFORMANCE Global Equities =/- Global listed Infrastructure = o.w. Communication = o.w. Oil & Gas Storage and Transportation =/+ o.w. Transportation = o.w. Utilities = Source: AMP Capital, Dow Jones, Bloomberg, December 2016 This scenario captures a full cycle with Global Equities performing strongly during the first movement on the back of increased growth, higher inflation expectations and diminishing real yields. However, as the second movement takes place (i.e. tightening monetary policy), rising real yields provide a headwind for valuation. In this environment, we would expect Global Equities to perform in line (or slightly underperform) Global Listed Infrastructure. Within our asset class, we would not expect a significant dispersion in the performance of the various sectors over the full cycle, with the exception of Oil & Gas Storage and Transportation, which should benefit from the relatively higher inflationary environment. Normalisation A normalisation scenario is the base case in which both inflation expectations and growth return to historical trends of c. 2.5%; this regime reflects strong growth and inflation with increasing real yields (1st movement). Central Banks are hiking in this environment as the nominal long term yield approaches levels consistent with historical averages. Table 5. Normalisation scenario Impact on Global Listed Infrastructure NORMALISATION INFLATION EXPECTATIONS FIRST MOVEMENT IMPACT SOVEREIGN YIELDS COMPONENTS ー Breakeven inflation + Nominal yields + Real yields + VALUATION/PRICE PERFORMANCE Global Equities + Global listed Infrastructure =/+ o.w. Communication =/- o.w. Oil & Gas Storage and Transportation + o.w. Transportation + o.w. Utilities - Source: AMP Capital, Dow Jones, Bloomberg, December 2016 In this environment, as growth and inflation expectations are relatively healthy, we would expect Global Equities to outperform Global Listed Infrastructure. Within our asset class, we would expect sectors with lower duration and higher sensitivity to economic growth (i.e. Transportation and Oil & Gas Storage and Transportation) to relatively outperform. AMP CAPITAL GLOBAL LISTED INFRASTRUCTURE 11
By investing in a truly diversified portfolio of listed infrastructure companies, we believe that investors can mitigate risk arising from macro factors such as interest rates. Key takeaways Financial markets usually overreact to increase in sovereign yields, as implied by short term price performance of Global Listed Infrastructure securities Since the beginning of this economic cycle, we have witnessed 4 periods of meaningful increase in sovereign yields, including the most recent one during the second half of 2016. Although all these periods have resulted in Global Listed Infrastructure underperforming Global Equities, it is important to note that, in the previous 3 occasions, the asset class recovered all the relative underperformance in the 12 months following these periods, highlighting, in our view, a market overreaction to a rising yields environment. As we take a longer term approach, the strong correlation between the performance of the asset class and its cash flow growth supports our view that Global Listed Infrastructure s investors should always focus on the underlying assets and their ability to generate visible and growing cash flows. The impact of rising yields should be taken into the context of Global Listed Infrastructure s diversification Given its differentiated nature and global footprint, the impact of macro variables is not homogenous across all Global Listed Infrastructure s sectors. As characteristics like duration, regulatory frameworks and exposure to growth differ from industry to industry and from region to region, it is not surprising that the various sectors of the asset class tend to perform quite differently during periods of rising sovereign yields. By investing in a truly diversified portfolio of listed infrastructure companies, we believe that investors can mitigate risk arising from macro factors such as interest rates. Moreover, we believe that the volatility of listed infrastructure equities arising from short term increases in interest rates often presents an opportunity for dedicated investment managers like ourselves to capitalize from the dislocation of value and price. Differentiating between nominal and real yields is crucial to understand the impact of interest rates on Global Listed Infrastructure s cash flow and valuation Due to the asset class long duration and diverse regulatory frameworks / contracts structures, Global Listed Infrastructure companies cash flow and valuation can be impacted on differently depending on changes in real yields and/or inflation expectations. As we transition to a different economic and financial environment (i.e. tail end of unconventional monetary policy), and given the recent volatility in global bond markets, we believe it is important to differentiate the impact of various nominal and real interest rates scenarios on the asset class, in order to provide a framework for portfolio construction and asset allocation. CONTACT DETAILS If you would like to know more about how AMP Capital can help you, please visit www.ampcapital.co.nz Important note: This document has been prepared to provide general information and does not constitute financial advice for the purposes of the Financial Advisors Act 2008 (Act). An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement (available from AMP Capital Investors (New Zealand) Limited website www.ampcapital.co.nz or by contacting the Client Service Centre on 0800 400 499), and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, AMP ) make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors. The Manager and Issuer of the AMP Capital Investment Funds is AMP Investment Management (NZ) Limited, Ground Floor, 113-119 The Terrace, Wellington. Copyright 2017 AMP Capital Investors Limited. All rights reserved.