A Myth Too Far

Infrastructure and rising rates

A Myth Too Far

There are many who believe rising interest rates pose headwinds for income-producing equities. Yet history suggests infrastructure stocks may be an exception to that rule—an important consideration for investors as the Fed prepares for rate hikes in June and beyond.


The assumption that rising rates are bad for income-producing equities such as listed infrastructure stocks is a common one, and not without reason;  in principle, as yields on fixed-income assets go higher, they look more attractive relative to dividend stocks. 

But that belief only makes sense if bond yields are the only thing changing when rates rise. That’s not necessarily the case.

Rates tend to rise when economic growth is accelerating or inflation is rising. A growing economy can be fertile ground for companies to grow sales and increase dividends. For some firms, rising inflation can mean more pricing power to support revenue growth.

Either way, revenue and dividend growth have the potential to offset the impact of inflation and rising rates on the real purchasing power of an investor’s dividend stream, and the underlying value of income-producing assets. Indeed, companies able to grow their revenues—and by extension, their dividends—have actually fared quite well during past periods of rising rates.

In that context, listed infrastructure assets could be especially well-positioned for a rising rate environment:

  • Regulated revenues – The prices that infrastructure owners like gas, water and electric utility companies can charge are often linked to inflation. Regulators also consider the impact that higher borrowing costs have on these companies’ cost of capital. As such, this has the potential to make infrastructure securities attractive hedges against inflation and rising interest rates.
  • Growth assets – Infrastructure assets such as airports, toll roads, railways and ports are “user-pays” assets. Their revenue depends on how extensively the assets are used. Rising interest rates are generally associated with an expanding economic environment, where consumer demand for the services of infrastructure companies typically tends to grow as well.

A Look Back at History

What the next interest rate cycle holds for listed infrastructure remains to be seen, but a look back atthe Federal Reserve (Fed) tightening cycle last decade attests to its potential durability. The Fed gradually, but steadily raised its target rate for two years—from  1.25% to 5.25% between June 30, 2004 and June 29, 2006.

During that period the S&P Global Infrastructure Index delivered strong results, outpacing the S&P 500 Dividend Aristocrats—those members of the S&P 500 that have increased dividends for at least 25 consecutive years—and the Bloomberg Barclays Aggregate Bond Index during the first 12-months of tightening, the second 12-months of tightening and for the entire period. In fact, across the full period the S&P Global Infrastructure Index generated a cumulative total return of 51.3% compared with 19.3% for the S&P Dividend Aristocrats and just 5.9% for the Bloomberg Barclays Aggregate Bond Index.

 

Fed tightening cycle 2004 - 2006

Fed funds rate and cumulative total return (%)

 June 2004 - June 2005June 2005 - June 2006June 2004 - June 2006
Fed funds rate1.25 - 3.253.25 - 5.251.25 - 5.25
S&P Global Infrastructure Index29.2417.0951.32
S&P Dividend Aristocrats7.0811.4119.30
Bloomberg Barclays Aggregate Bond Index6.80-0.815.94

Sources: Bloomberg and U.S. Federal Reserve. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Conclusion

With the U.S. economy continuing to grow and the global economy picking up steam, the Fed appears increasingly committed to normalizing interest rates after a long period of extraordinary monetary policy accommodation. Its expected path to interest rate normalization is a gradual one unless an unforeseen acceleration in inflation develops. Either way, a well-diversified exposure to listed-infrastructure assets is one choice investors have to hedge against inflation and rising interest rates.


To learn more about infrastructure read Understanding Infrastructure from Legg Mason manager RARE.

 

 

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.

Diversification does not guarantee a profit or protect against loss.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.