One of the biggest misconceptions investors can make is that infrastructure and utilities companies are interest rate sensitive, according to Premier Asset Management James Smith.
The co-manager of the £54m Premier Global Infrastructure Income fund said in fact that these companies should outperform in this scenario.
“As a specialist investor in utilities and infrastructure, the question I am most often asked is: ‘How will the sector perform should interest rates increase?’” he said.
“We acknowledge that short-term concerns over rising rates can impact the sector, largely because the market believes that they will.
“We saw this in the pull back in the sector at the end of 2016, in response to Donald Trump’s election and the perception that his expected expansionary fiscal policies would result in increasing US, and in due course global, interest rates.”
Indeed, as the below shows, the S&P 500 Utilities sector fell 9.67 per cent from the end of October 2016 to 11 November – shortly after Donald Trump won the election – though it has since made these losses back, being up 13.76 per cent over the last 12 months.
Performance of indices over 1yr
Source: FE Analytics
“When interest rates go up people often say that utilities or infrastructure are bond proxies and what they mean implicitly by that is that when you buy one of these companies you have a defined long-term relatively fixed stream of earnings (hence dividends),” Smith said.
“If interest rates go up then you would discount those dividends at a higher rate to get back to today’s value. Therefore those future dividends would be worth less and the share price should be lower.”
However, while this works in principal, in reality utilities and regulated infrastructure companies should actually be net-beneficiaries from rising interest rates.
Smith said the thought that utilities and infrastructure companies are in some way like bond proxies are wrong, with the below graph showing that the UK utilities sector has little correlation to the yield available on UK 10 year Gilts.
“The theory that interest rates led investors to be happy with lower yields on the sector, thus pushing up share prices, simply isn’t the case,” he said.
“Indeed, the sector’s yield has increased at the same time the yield on UK government debt has decreased, the exact opposite of what the theory would suggest.
FTSE All-Share Utilities Index yield vs UK Government 10 year gilt yield over 10yrs to 30 April 2017
Premier Asset Management
“I would therefore suggest that an upwards movement in interest rates would be unlikely to lead investors to require materially higher yields on utility investments, thus forcing down share prices in the sector.”
Most utilities – particularly the ones that Smith invests in – are regulated utilities such as National Grid, SSE and Pennon.
“They are operating a natural monopoly. Those tend to be regulated with an allowed rate of return which is a real rate of return,” Smith explained.
The key figure for investors to look at is the value of the regulated asset base, or the RAB, which is the number that the regulator uses as a valuation for the company’s assets.
The manager said: “Let’s say you have a water company with a RAB of £10bn. If it is allowed a 5 per cent rate of return it would make £500m of profits. If interest rates went up and their return went up to 6 per cent they would make £600m – that’s the way it works but the valuation of the share price comes back to that RAB.
“So the first most basic calculation is what is the RAB – what the regulator is saying these assets are worth. Take off the debt and you then have a valuation of a company’s equity.
“If you take the UK water sector, every time they have a period resetting of rates with a review, the company is allowed a new level of return.
“If interest rates in the meantime go up, then their allowed return would also be increased, therefore their profits would also be higher which offsets this discounting effect of interest rates. So effectively a regulated utility should be ambivalent toward the level of interest rates.”
Indeed, the manager noted that over recent years, UK utilities’ dividends have actually been more under pressure because interest rates have come down and therefore their allowed returns have come down.
“If interest rates went back up again to a more normal level, profitability would go up and they would probably increase their dividends,” he added.
The only thing for investors to be made aware of in this case, he said, is that it may take some time for the regulators to agree to increase the rate of return.
“There are a few lag effects within this so you might have to wait a few years until your allowed returns are next reset, so there is some sensitivity, but it is nothing like what the market believes and the empirical evidence supports that,” Smith said.
There are two type of regulatory model in the sector, however, with the second being concession models typically found in infrastructure companies, and these may be slightly more impacted by interest rate hikes.
“You simply have a tariff – such as a toll road – and you have agreed with the regulator that you have a fixed tariff that is inflation adjusted for the next 30 years,” Smith explained.
In this case, the level of real interest rates are “significant” for that company, he said, as they are not able to renegotiate this level for a fixed period.
“To the extent that interest rates follow inflation it is a pass-through but if real interest rates went up that asset would not be as valuable as it might once have been. Therefore infrastructure is probably slightly more interest rate sensitive.
“Having said that it all depends on the asset. For instance many airports are regulated in exactly the same way as a utility company – so they have a RAB, an allowed return on that asset base.”
Overall, he said “essentially people are massively over concerned about interest rates”.
“I really wouldn’t want to overemphasise interest rates. It is not a big part of our everyday thinking. I know a lot of other people do but we don’t.”
Smith has co-managed the three crown-rated Premier Global Infrastructure Income fund alongside Claire Long since June 2012.
Since he joined the fund it has returned 97.22 per cent, putting it in the second quartile of the IA Global Equity Income sector over the period, as the below shows.
Performance of fund vs sector since manager start date
Source: FE Analytics
The fund, which was previously named the Premier Global Utilities Income fund, has a yield of 5.09 per cent and a clean ongoing charges figure of 1.14 per cent.