At the moment, because of their attractive return profiles, many closed-ended funds are trading on heavy premiums – in some cases over 20 per cent. This need not be an issue, but investors should consider what might cause this premium to be eroded away.
The implied value of infrastructure assets is generally assessed on a discounted cash flow basis, and therefore the level of long-term interest rates is an important factor within the valuation process.
Expectation of a change in the interest rate cycle and higher longer-term interest rates would result in future cashflows being discounted at a higher rate, thereby reducing their implied present value.
At the same time, the improving economic environment that would likely accompany rising interest rates may improve the relative attractiveness of more traditional yielding assets such as corporate bonds and commercial property and draw capital away from infrastructure.
We are already seeing the beginning of a steepening in the yield curve in the US. It remains to be seen whether this continues.
Inflation risk. Many infrastructure assets have a degree of inflation sensitivity built into the negotiated contracts.
This means that levels of inflation that sit within the bounds deemed to be acceptable by central banks will have a positive effect on infrastructure assets.
However, sustained spikes in inflation to unexpected levels could lead to knee-jerk reactions from central banks keen to put the genie back in the bottle and, as mentioned above, materially higher interest rates would be a likely negative for the infrastructure sector.
Political risk. Another consideration is political interference.
The Labour party under Jeremy Corbyn had a very dim view of old-style private finance initiatives (PFIs).
At the time of the last election there was concern that public/private partnership contracts would be re-written and assets taken into national ownership with inadequate compensation. It is an illustration of the political risk facing infrastructure anywhere.
Investors may feel that that risk has now subsided in the UK . But remember, these are long-term assets and it is impossible to predict with confidence what may happen over their lifetime.
Economic risk. As indicated earlier, assets whose returns depend upon ‘availability-based revenue’ will be more vulnerable to cyclical risk.
And nearly all infrastructure assets will be exposed to some degree to cyclical risk if the state of the economy undermines the ability of the users of the assets to fulfil their contractual obligations.
Mitigating risk through diversification
Diversification within infrastructure exposure is important in terms of both geography and the underlying asset type.
