Core infrastructure: keeping it real
As discussed previously1, core infrastructure has generally performed well in spite of the Covid-19 crisis and subsequent macroeconomic challenges which persist today. Though, as in any crisis, there are lessons to be learned. In this piece, we aim to provide a first look at those lessons as the crisis continues to unfold.
To deliver on its promises of stability and resilience, infrastructure investing should be done through a predominantly core investment strategy. Starting with the topical debate on inflation-protection, we need to emphasise that it is not guaranteed by the indexation of revenues alone; operational costs and financing costs can also expose the investment to inflation when it surges.
On the financing front, the ultimate lesson that needs to be re-learned in almost every crisis is the importance of prudent debt profiles. Short term, variable rate debt is never appropriate for core infrastructure, since the aim is to provide downside protection.
A more important lesson that needs to be considered by investors is the potential damage of procyclical behaviour and short-termism. Infrastructure is by design a long-duration asset class. Investors focusing on short term tactical gains in their asset allocation tend to overlook and miss its longterm benefits.
Core infrastructure, rightly done
Our preferred definition of core infrastructure relies on the long-term predictability of yield; that is fluctuations in macroeconomic variables such as inflation and interest rates should not significantly affect the real (inflation-adjusted) yield to equity. Infrastructure investments with inflation-protection ability and prudent debt profiles are performing extremely well through the ongoing market turmoil in terms of net asset values and, more importantly, yield. Having said that, the intricacies of the inflationprotection ability and prudent debt profiles are the two main lessons learned:
Inflation-protection ability is not automatic even when revenues are indexed to inflation. In many cases, revenues are inflation-adjusted with a lag. Even when the adjustment is automatic, it is at best annual. In addition, the regulator or policy-maker, considering the “cost of living crisis,” may decide to delay and spread the adjustment over a few years. The costs on the other hand, increase immediately in most cases unless long term contracts on costs are also in place. For instance, many non-energy infrastructure investments, such as regulated utilities and transportation assets, had huge immediate increases in their energy costs in the current crisis, while the revenues did not get adjusted in tandem. The core investment strategy should manage the risk on cost inflation as well.
Debt profile can break an investment single-handedly when the capital markets turn. When capital markets are calm, as it is well-known, the irrational exuberance kicks in and the risks around the debt profile is overlooked as the cost of debt is stable or declining. Short-term, variable rate debt is never consistent with the core investment strategy, but it is cheaper, so investors tend to rely on such debt profiles to improve the expected returns for equity, especially when capital markets are calm. The discipline that all investors claim to have must start with a prudent approach to the debt profiles by focusing on longterm fixed rate debt – in good times.
Short-termism hurts: a current example
While core infrastructure is performing extremely well relative to other asset classes, some institutional investors are focusing on short-term issues, behaving pro-cyclically and overlooking the benefits of the long-term approach. Procyclical behaviour and shorttermism are well-known and well-established facts for institutional investors.2
Here is a simplified example of an actual investor statement that nicely demonstrates the shorttermism: “I can get 6-8% yield in private debt now, why should I consider core infrastructure equity that targets 7-9% return?”
There are three major issues with this statement:
Though it has been the convention so far, and admittedly infrastructure managers bear fault, core
infrastructure returns should not be quoted in nominal terms. Since inflation-protection is strong
in infrastructure investments, as the representatives of our asset class we should always quote return targets in an inflation-adjusted way – and incorporate inflation into the performance metrics and fees. Core infrastructure equity can provide 5-7% real return in today’s market in our view. In a 2% long-term inflation environment, 5-7% real is equivalent to 7-9% nominal.
The consensus macroeconomic view, that we also agree with, is that the high inflation and high interest rate environment will be short lived. Both inflation and interest rates will come down before 2025. Based on our own internal forecasts as of March 2023, average inflation in the 10-yr period between Jan-2022 and Dec-2031 will be around 3% in most high-income OECD economies, implying nominal returns for core infrastructure in the 8-10% range.
Arjun base case forecasts on inflation and government bond yields as of March 2023
10-yr government bond yield forecasts
Source: OECDStat for historical values, Arjun Research for Q1-2023 and afterwards
The statement compares yield to the return. Core infrastructure targeting 5-7% total real return, also targets 2-4% real yield. While the return target is based on the long-term, e.g., around 10 years, yield targets are usually shorter term, in some cases annual.
For instance, most forecasts for 2023 inflation in the euro area range between 4 to 6%, making core infrastructure’s nominal yield target in 2023 approximately equivalent to 6-8%.
The statement also demonstrates a very strong case of short-termism. Debt investments are currently yielding 6-8% based on government bond yields at 3-5%. If government bond yields go down as expected in 12 to 18 months’ time, the debt investments will theoretically have an increase in their mark-to-market capital values, driving a higher total return.
However, unfavourably for yield seeking investors the original 6-8% yield will only be available in the short term as even when the margins are fixed the fall in base rates triggers a decline in all-in rates. A further challenge is that borrowers predominantly prefer shorter durations, e.g. balloon payments with no penalties, expecting to refinance as soon as the rates go down.
Even if we put the refinancing possibility aside, considering a buy-and-hold strategy, equity investment significantly outperforms the debt investment in the long term. Here is a simplified example:
Investment D is an investment-grade debt investment that yields 300 bps margin over 10-yr government bond yield3; no amortisation with a balloon payment of the capital at the end of 10 years.
Investment E is an infrastructure equity investment that targets 5% real return and 2% real yield, conservatively on initial investment (not on NAV).
Based on simple inflation and interest rate forecasts consistent with the consensus, there is a case where D and E has similar nominal yields for 10-years, but E provides a much stronger real return as the asset value appreciates in real terms, while D’s capital stays constant in nominal terms.
Infrastructure is an attractive asset class for institutional investors, demonstrated by the fact that
allocations to it have been steadily increasing over the past two decades. The main reasons for its perceived attractiveness in our view is infrastructure’s long duration and defensive characteristics.
This attractiveness creates two challenges for investors. One is an adverse selection challenge. As the asset class is relatively new and quite wide in terms of the sub-sectors, the investment strategy definitions are not yet settled. Every manager has an incentive to label their strategy as a core strategy. However, just from an inflation-protection perspective, indexation of revenues to inflation is not enough to achieve the stability and resilience of a core investment. Costs, operational and financing, must also be fixed to the greatest extent possible.
As marketing materials highlight the indexation on the revenue side, and cost analysis can be too
complicated, investors may end up investing in riskier investments while considering them to be core. The second challenge is the inherent short-termism of asset allocators at institutional investors, which creates a significant mismatch for infrastructure investments as naturally long duration investments.
As our asset class matures, we will overcome some of these challenges, and some lessons will be needed to be learnt again and again, from one crisis to the next.
1 See Arjun Research paper “What to expect when you are expecting inflation, rising interest rates, recession”, August 2022, available at https://www.arjuninfrastructure.com/post/what-to-expect-when-youare-expecting-inflation-rising-interest-rates-recession
2 For a survey and empirical evidence on procyclical behaviour, see IMF Working Paper “Procyclical Behaviour of Institutional Investors During the Recent Financial Crisis: Causes, Impacts and Challenges”, September 2013. Available at
For a similar survey on the causes of investor short-termism, see FCLT Global publication “Rising to the challenge of short-termism” June 2016. Available at
3 In reality margins are based on base rates such as SONIA or EURIBOR rather than long term government bond yields, so 300 bps over government bond yields is a generous assumption.