When it comes to interest rates and investing in infrastructure, there’s more to the story than conventional wisdom indicates.
“Periods of rising interest rates are often associated with a decrease in infrastructure valuations,” said Lachlan Pike, portfolio manager at Maple-Brown Abbott in Sydney, Australia, during a mid-June interview. “However, we believe this rule is far too simplistic.”
That view overlooks the fact that interest rates are driven by changes in economic variables, such as growth and inflation. “Different assets display different levels of sensitivity to interest rate movements,” depending on those variables, he said.
His firm assesses a company’s assets to understand how they’re affected—or protected—from changes in inflation and real interest rates.
Read: Advisors concerned about volatility, rising rates: survey
Investors’ perceptions of the interest-rate sensitivity of assets are particularly misguided for regulated utilities, said Pike, whose firm manages the Renaissance Global Infrastructure Fund. An accurate assessment of a utility requires “a deep understanding about the mechanisms used in its regulatory jurisdiction and also company-specific factors,” he said.
Utilities up close
As natural monopolies, utilities are typically “highly regulated in most jurisdictions, with clearly set parameters around how the business earns […] allowed returns,” said Pike.
That level of regulation can significantly protect the underlying value of assets when inflation or interest rates rise. For example, utilities can generally pass on increases in interest rate costs to customers. And allowed return on equity (ROE) is usually linked to bond yields, so underlying earnings have the potential to increase along with rising rates.
When assessing regulation’s effects, Pike’s firm scrutinizes three key factors: how earnings are set; how allowed ROE is calculated; and the length of regulatory periods.
“We want to understand whether earnings are set on real or nominal returns, and thus [whether] movements in inflation [are] an explicit part of the annual allowed return,” Pike said. Earnings could instead be based on movements in interest rates, he added.
It’s also important to analyze whether allowed ROE is formulaic or based on regulatory decisions—the latter scenario could introduce an arbitrary element. The length of regulatory periods dictates how long the utility must wait until it can pass rate changes on to customers, Pike explained.
This type of analysis reveals that the attractiveness of global utilities can vary widely when interest rates move, versus all utilities seeing a drop in valuation. For example, an Australian-regulated utility with the ability to “directly pass through movements in inflation,” and which has a relatively short regulatory period, may have lower sensitivity to interest rates, said Pike.
In contrast, “[a] U.S.-regulated utility under a nominal framework that has a long period until its next rate reset may have much larger interest-rate sensitivity.”
A utilities pick that holds water
The Renaissance fund’s largest position in regulated water utilities is in Severn Trent Water, which provides fresh and waste water to about 8 million people in the U.K.
That utility is regulated under a “transparent real return framework, […] indexed annually to account for movements in U.K. inflation,” said Pike. Regulatory periods are five years, and allowed ROE is set at the beginning of each period, through “a rigorous consultation process.”
As a result, “earnings should be very predictable, and are typically able to grow in line with inflation, with dividends likely following a similar path,” said Pike. And, should U.K. inflation push interest rates higher, “Severn Trent Water has strong regulatory return protections to offset much of this interest rate risk,” he added.
Across the board, utilities are generally well-insulated from geopolitical risk, said Pike, since they provide essential services. However, political discussion sometimes gets heated concerning regulation or ownership, as evident in the U.K.’s ongoing debate about private versus public utilities. It’s a debate Pike will monitor for potential price opportunities.
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