The big inflation misconception deterring you from this asset

Biases and myths are common in investing. After all, it is such a vast landscape that no one can truly be an expert on all aspects. This can see us using scrappy rules, that may have some hint of truth, to try and make sense of areas we don't fully understand. I hardly need to explain why this can be a problem. It can mean investors avoid assets that could be a useful addition to their portfolio – or on the flip side, use assets they might be better off avoiding.

While every type of investment has its myths and rules, infrastructure tends to be hit particularly hard by misconceptions.

Whether you see it as boring (subjective), expensive (depends on what you compare it to), or even have trouble identifying what even classifies as infrastructure (it’s vast…), many investors steer clear of this asset class. But none of the above is typically the biggest deal-breaker for investors.

Sarah Shaw, Global Portfolio Manager and CIO for 4D infrastructure, says the biggest misconception about infrastructure is the idea that it's a bond proxy. In a period of inflation and rising interest rates, you can understand why that view might deter many investors.

Infrastructure and the bond proxy myth

It’s worth going into more detail about the myth, so here goes.

When you think about infrastructure, front of mind might be highly regulated utility (nominal rate) companies where rates are typically set, and to change them might require certain policy levers which can be time-consuming.

In a period of rising inflation, it’s fair to assume that these types of companies might start to feel pressure. The cost to operate will be affected, while the returns the company makes will be devalued by inflation until such point the company is able to increase rates (depends on the policy requirements but can be a long time).

This is where the association with bonds comes in.

In a period of inflation and rising interest rates, a fixed-rate bond will still pay the same coupon – but inflation means that the coupon has a lower value for the investor. Should the investor want to sell the bond, its price will also have gone down. In simple terms, no one wants to pay a premium on a bond that pays 15bps, when they could pay that same premium for a bond paying 300bps.

Sounds like the myth is proven?

Not yet. Though it’s a fair point to make about nominal rate utilities which don’t typically have inflation indexing incorporated into their rates.

Looking at the broader infrastructure space

Shaw points out that nominal rate utilities are a very small segment of infrastructure, so grouping the entire space as a bond proxy isn’t an accurate comparison.

“We’ve got two distinct and economically diverse sub-sectors in infrastructure. On one hand, we have ‘user-pays assets’ like toll roads, airports, rail companies which are 100% correlated to economic activity and include explicit inflation hedges. They are also very high margin. In the current environment, they capture the growth and economic reopening, as well as inflation and compound this into their valuations,” Shaw says.

The second sub-sector Shaw looks at, she describes as "economically immune". This is where she groups essential services and basic needs. For example, water or electricity.

“These are your last resort in terms of affordability, the last thing you want to do is turn off your lights or water. The structure of their regulatory environment measures returns independent of volumes. Some of these could be considered a bond proxy - namely the nominal rate utilities. However, even within this sub-sector you have a segment that has an inflation pass through - the real rate utilities - which are not a bond proxy and offer solid upside in this environment,” says Shaw.

She also points out that regional distinctions mean you can’t universally apply thinking for either growth or opportunity. For example, while Europe is experiencing a challenging economic environment, Shaw sees massive opportunities in terms of energy infrastructure growth with accompanying government commitment to spending. On the flip side, she sees less diversity in the US and more nominal rate regulated utilities so it’s less of an opportunity set.

In short, the bond proxy comparison falls flat for vast proportions of the infrastructure space. You can see why the myth started, but applying it across the board is a mistake.

How to assess infrastructure (and avoid bond proxies)

Shaw’s approach to infrastructure requires companies to have a defensive, visible, resilient earnings stream. She also uses a 10-factor assessment of company quality considering industry structure, asset quality and responsible investment factors which is compared to the current valuations for the company to assess whether it is expensive or good value.

As part of the process, 4D factor the macro environment and assess individual country risks and opportunities before looking at the infrastructure companies.

“In the current environment, we are overweight user-pays asset and real-rate utilities and underweight nominal-rate utilities,” Shaw says.

You can find out more about the opportunities across the infrastructure space and using it in inflationary periods in this recent interview:

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