Are infrastructure stocks a good buy right now?
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Infrastructure stocks have performed well in a low bond yield environment, even with their relatively high valuations, but there is some uncertainty about whether this will continue.
The defensive, bond-like characteristics of infrastructure stocks have appealed to both institutional and retail investors in recent years, drawn by their income potential relative to low fixed-income yields.
Super and pension funds rank as some of the biggest shareholders in this space, alongside individual investors, particularly those approaching retirement.
"Infrastructure is a good fit for institutional funds because of the need for regular income flow, a predictable earnings stream," says Greg Goodsell, global equity strategist at 4D infrastructure--an asset manager owned by Bennelong Funds Management.
"The attraction of infrastructure for retail investors is typically the predictability of earnings, and they also tend to be higher-yielding in terms of dividends or distributions, for much the same reason it's attractive to super funds and other institutional investors."
Goodsell groups infrastructure assets into two broad categories: regulated utilities and user-pay assets.
Distributors of water, electricity or natural gas are examples of the former: "They're natural monopolies, because it doesn't make sense to have two power lines running down the same street, or two gas pipelines," Goodsell says.
To temper the monopoly environment, a government entity then typically regulates how much they can charge. "So it's a very defensive asset class ... it's a nice predictable earnings stream that comes out of it," Goodsell says.
"They have much better growth profiles, because [their services are] linked much more directly to GDP. Traffic flows on a particular bridge or tollway will typically be linked to state GDP, so for instance, if state GDP is 2 per cent, typically the rate of growth for traffic flow will be 4 or 5 per cent," he says.
Goodsell also highlights the inflation protection of user-pays assets, which is built-in via concession deeds that are typically signed with the state for a fixed period, such as 25, 50 or 100 years. The concession deed will outline how much the asset operator can inflate tolls over the set period.
"The regulatory period is typically five years, so if you get a big interest rate or inflation hike during that period, the utility goes to the regulator, and says 'we need to adjust our rates upward to recoup that loss,' so it's a nice predictable revenue stream," he says.
While there are some key differences between these two types of infrastructure assets, "they all have some degree of regulation or concession deed which gives them some degree of monopolistic market power--not pure monopolies, but very strong power over their markets," Goodsell says.
Morningstar equity analyst Andrew Moller points out there are some risks infrastructure investors need to be aware of.
"For instance, if bond rates move, with a negative correlation between 10-year bond rates and stock prices," he says.
With official interest rates around the globe currently at historic lows, or even negative, the bond-like characteristics of infrastructure stocks have attracted many retail investors that would traditionally have bought fixed-income assets.
"Such stocks were particularly sensitive--because of the thirst for yield, people were willing to pay up for access to that," Moller says.
With bond yields already rising, and if investors continue to sell out of infrastructure stocks in favour of fixed income, their high valuations could begin to unwind.
This risk is offset in Australia by large-scale institutional investment, with valuations of many infrastructure stocks supported by both listed and unlisted vehicles such as pensions and super funds.
The economic moats of infrastructure stocks such as Transurban and Sydney Airport also add to their appeal.
"The reason why they have moats is because they're basically monopolies ... operating in industries with very high fixed costs and barriers to entry," says Moller.
"I can't see the moats changing, but valuations could come off as discount rates rise, which are heavily influenced by the 10-year-bond rate."
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Glenn Freeman is Morningstar's senior editor.
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