Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn
About

News

How defensive stocks ride out rate volatility

Glenn Freeman  |  03 May 2019Text size  Decrease  Increase  |  
Email to Friend

Utilities and infrastructure companies are usually described as a “defensive” asset class because they deal in long-term contracts that help them ride out volatility – a factor that also affects their reaction to interest rate movements.

And like property trusts, utilities and infrastructure companies also have bond-like characteristics: they may not grow very quickly, but they provide a reliable income stream over the longer term.

Tollroads operator Transurban Group (ASX: TCL) and gas pipeline company APA Group (ASX: APA) are two key examples in the Australia, says Morningstar senior equity analyst Adrian Atkins.

Transurban has a wide-moat rating – a Morningstar rating indicating a sustainable competitive advantage – because of its scale and strong barriers to competition. The centrepiece of its portfolio is a network of 17 toll roads in Australia and North America.

APA Group, which holds a narrow moat due to its size and high capital costs for new entrants into the gas infrastructure space, forms long-term contract arrangements with energy retailers, LNG exporters and major mining and industrial companies.

On average, these contracts are in place for more than 10 years and up to 30 years for some of the largest projects.

As Atkins says, this longevity is key to shielding them in times of economic turbulence.

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

"So, if economic conditions deteriorate, then it won't hurt their revenues too much because they've got contracts locked in,” he says.

"But when interest rates fall, and that also means that bond rates have fallen, this makes APA's yield rate look more attractive to investors.”

This in turn pushes up the share price, until the dividend yields eventually return to more bond-like levels.

Infrastructure and utilities companies carry high levels of debt to cover the high up-front capital costs of their large-scale projects. This means they are affected by domestic interest rates.

For instance, APA Group's total level of gearing relative to assets was 65 per cent in fiscal 2018, and its outlaid capex for new projects was more than $850 million, across both growth and maintenance capex.

"These guys have huge amounts of debt, so when bond yields fall, they refinance their debt at lower rates," Atkins says. For example, assume the company previously paid 7 per cent a year. If interest rates fall to 4 per cent, the difference in that change is potential profit it can pay out to shareholders.

Atkins says this might save companies like APA and Transurban hundreds of millions of dollars.

"That's why their share prices have done quite well over the last 10 years.

"But remember also that just because the Reserve Bank cuts the short-term bank bill swap rate, that might not really drive a change in share prices, which tend to respond more quickly to the 5- or 10-year government bond yields.  Bonds and shares move so much quicker than the RBA."

Australian government bond yields have already fallen to historic lows over the last six months: 1.3 per cent for the five-year and 1.7 per cent for the 10-year bond.

While about 90 per cent of APA Group's assets are unregulated, and entirely subject to this shift, about 10 per cent are regulated by the government.

Regulated entities respond differently to Australian interest rate movements – Atkins cites Spark Infrastructure (ASX: SKI) and AusNet (ASX: AST) as examples here.

AusNet owns three electricity and gas networks in Victoria - two electricity grid networks and a gas distribution network.

Spark Infrastructure owns large stakes in three electricity distribution networks - two in Victoria and one in South Australia.

"If interest rates go up, that's a good thing for them, because they can then charge higher tariffs," Atkins says.

These tariffs are set in negotiations with a government regulator - the Australian Energy Regulator in the case of AusNet, which resets the tariffs every five years.

Both Spark and AusNet are awarded three-stars by Morningstar analysts, partly due to Morningstar's longer-term view on official interest rates.

Three stars – previously  “hold” – indicates that Morningstar believes investors are likely to receive a fair risk-adjusted return.

"While we don't know what's going to happen in the near term to interest rates, at Morningstar, we think it's fair to assume rates will start rising again over the medium term," Atkins says.

By comparison, APA Group and Transurban hold only two stars.

Two stars – previously  “reduce” – suggests investors are likely to receive a less than fair risk-adjusted return and should consider other alternatives.

is senior editor for Morningstar Australia

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend