Infrastructure: Price Vs. Valuation

Infrastructure: Price Vs. Valuation

Rising bond yields can have a different impact on the fundamental valuation and market price of regulated utilities and user-pay infrastructure. An in-depth understanding of these impacts enables an active, benchmark-unaware manager to better navigate through the economic cycles.

A summary of the basic drivers of revenue for the two types of listed infrastructure is needed to understand the impact of rising bond yields on each.

For regulated utilities the most important driver of earnings is the ‘allowed return’ that a regulator determines the company should earn on their assets.

If an asset (such as the poles, wires and pipes that form the gas, water and electricity transmission) earns too much, then the company may be required to lower its prices. Conversely, if the asset earns too little, then the company can increase its prices. This mechanism leads to a relatively stable earnings and cash flow profile over time. Often, the prices of these essential services are linked to inflation and, as such, these assets also act as a good hedge for inflation.

By contrast user-pays infrastructure usually has a concession contract or regulator that determines the price they can charge for the use of their assets. However, the company’s revenue is dependent on how many people use their assets – this is often referred to as patronage or volume risk. These physical assets, namely rail, airports, toll roads, ports and telecommunications towers and satellites, move people, goods and services throughout an economy. Therefore, as an economy grows, develops and prospers, their revenue also typically grows. So, as more people use toll roads as an alternative to public roads, we see toll road operators adding additional capacity to their networks to meet this demand.

Given this context, let’s examine how rising bond yields can impact the fundamental valuation and market price of listed infrastructure assets.

The fundamental valuation is the implied or intrinsic value of a company. This can be determined using a methodology which examines the expected cash flow a company will generate and the risks associated with those future cash flows. Investors account for risks by discounting the expected future cash flows at a rate that reflects the risks. This rate is formally known as the discount rate. If cash flows remain unchanged, theoretically, a rise in bond yields will increase the discount rate which reduces the value of expected cash flows, thus reducing the fundamental value of the investment. By contrast, the market price is the share price of the company.


The impact of rising bond yields on regulated utilities

From a fundamental valuation perspective, as bond yields rise utility companies can go back to their regulator and seek an increase to their ‘allowed returns’. Generally, allowed returns are calculated utilising the Capital Asset Pricing Model (CAPM). A key input into the CAPM is the risk-free rate, to which many regulators use the ten-year government bond yield as a proxy. Therefore, as the ten-year bond yield increases, the risk-free rate also increases along with the utility company’s ‘allowed returns’. However, the increase in cash flows, a result of the increase in allowed returns, is offset by an increase in discount rates. As such, a rate rise has a neutral impact on fundamental value.

Therefore, for utilities, the exposure to interest rates are limited to the length of time between the reset periods with many companies fixing their debt at the prevailing rates. The timing of these regulatory resets varies across jurisdictions. In Australia, for instance, utility companies have a five-year regulatory reset which generally means their allowed returns are adjusted every five-years. In the United States, however, this review is conducted on an ad-hoc basis which means that allowed returns in the US are adjusted at a much quicker pace.

The impact on market price, on the other hand, is quite different as the market generally prices Utility companies based on their dividend yields, which for yield-driven investors appear relatively less attractive as bond yields rise. As a result, these stocks typically experience a short-term sell-off. However, for long-term, active investors this short-term mispricing may present a good buying opportunity as the fundamental valuations underpinning these securities remain unchanged.


The impact of rising bond yields on user-pays infrastructure

The relationship here is very different. One reason is rising interest rates are generally an indication of a growing economy. Those infrastructure companies whose revenues are linked to consumer behaviour, such as railway operators and airports, usually benefit from increased demand and, as a result, the market usually bids up the price of these assets. In other words, post-rate rise, the market price of user-pay infrastructure typically rises.

However, from a fundamental valuation perspective the impact is not as clear-cut. Given the economic-sensitive nature of these assets, valuation is dependent on whether the rise in nominal bond yields is driven by inflation expectations or by real yields.

Inflation-driven bond yield rises: As inflation is often reflected in contractual frameworks, a long-term rise in bond yields that is accompanied by a similar rise in inflation should see the rise in cash flows offset the rise in discount rates. As such, inflation-driven bond yields should not have a material impact on the fundamental valuation of user-pays infrastructure.

GDP-driven bond yield rises: Higher real bond yields (holding inflation as a constant) would have a negative impact on fundamental valuation. This is because the asset owner is unable to re-price their services and, as such, cash flows remain unchanged.


The need for active management

Many investors with current exposures to listed infrastructure, or are considering allocating to this asset class, may be concerned about how a rise in bond yields may impact performance of the asset class, in particular, the more defensive sectors within it, such as utilities. However, an unconstrained investor can tilt their portfolio away from utilities and into those companies with lower interest rate sensitivity. Additionally, they can focus on growth-oriented utilities which themselves have lower interest rate sensitivity.

Lastly, it is important to reiterate that while the movement in bond yields is important, they are only one component in determining fundamental valuation. Changes in growth, asset lives and other operating factors are equally as important.