By David Fickling
The specter of rising bond yields is haunting the $1.7 trillion infrastructure market.
As the rate on U.S. Treasuries has jumped north of 3 percent over the past six months, the value of infrastructure funds has slumped. From a high of about 2.37 times book last September, the price of the S&P Global Infrastructure Index has slipped to less than 2 times in a series of moves that closely mirror the 10-year yield.
There’s a simple reason for this. Infrastructure is often highly leveraged, so it’s unusually exposed to increases in borrowing costs. Furthermore, such long-term assets tend to be valued on a discounted cash-flow basis: Raise the government bond yield and the “discount rate” bit of that calculation should rise too, reducing the value of the project and causing impairments to weigh on the earnings of the investor.
For those alarmed by this prospect, Macquarie Group Ltd.’s annual results Friday look like a tonic. The Australian investment bank, by some measures the world’s largest infrastructure investor, rose to a record intraday high of A$110.95 after posting a 15 percent rise in net income, matching the most optimistic analyst estimates for the year.
Macquarie has a diverse range of businesses, but infrastructure was no laggard in contributing to that result. Net income from the Macquarie Asset Management business increased 10 percent from a year earlier, and made up about 41 percent of the rise in total net income before corporate costs. Only the Macquarie Capital investment banking advisory segment did better – and that unit’s expertise in infrastructure means it’s not entirely divorced from the same market.
There are a few keys to Macquarie’s ability to ride out rising borrowing costs. One is that its balance sheet is skewed toward the longer term: The weighted average term to maturity of its longer-term funding is 4.6 years, while debt and paper maturing within 12 months was just 17 percent of total funding at the end of March. That compares to short-term funding at 44 percent of the total during the 2008 financial crisis, according to Bloomberg Intelligence analyst Sharnie Wong.
It’s also the case that infrastructure doesn’t stand still when borrowing costs rise. A toll road can expect to see more traffic as a result of the same growth that fuels higher interest rates, so cash flows should increase to match the higher interest payments. One telling aspect of the way infrastructure valuations have tracked bond yields in recent years is that they’ve tended to slump each time rates take a step up, but then resume their upward momentum as investments demonstrate their resilience to the new environment.
That all sounds like good news – but only up to a point. It’s still relatively early days in a more normal interest rate environment, and yields only started rising in the last three months of Macquarie’s second-half result. Furthermore, we’re a long way below the levels that caused its near-crash during the 2008 financial crisis. A frog can swim around happily if you raise its water temperature from 20 degrees celsius to 35; that doesn’t mean it will be equally content if you turn the heat up to 50.
As we’ve argued before, the extreme valuations at which infrastructure assets have been changing hands in recent years could be a worrying sign for either investors or public users. Macquarie’s 97 billion rupee ($1.5 billion) winning bid earlier this year for a toll-road project in India came in at more than 50 percent above what the government was expecting, according to the Economic Times. Justifying such expenditure could be harder in a time of rising rates.
Infrastructure has proved itself so far – but its toughest test still lies ahead.