April 3, 2023

Why Infrastructure Investments Are the New Bonds

Investments in physical assets did better and promise more than fixed income.

Reported by Larry Light

Art by David Plunkert

The framework of civilization—infrastructure—also is increasingly a go-to holding for investors, who want steady income (often in high single digits) without the inflation vulnerability of bonds or the volatility of stocks. Performance in infrastructure is also noncorrelated to those traditional assets.

Plus infrastructure investments are available in both public and private markets.

Bonds, like their fellow legacy investment class, stocks, have gotten skewered over the past year. Infrastructure, however, can offer the same steady results that fixed income once did. The Bloomberg Agg, which measures bond performance, dropped 13% in 2022, and the S&P 500, the stock benchmark, fell 19%. Infrastructure, whether on public or private markets, didn’t lose and is expected to romp going forward.

Hence, infra’s increased investor popularity. Allocators committed 4.6% of their holdings to infrastructure in 2021 and targeted 6.6%, meaning they were scrambling to extricate themselves from other allocations and plug the money into investments tied to physical assets. Fundraising for the asset segment’s funds hit $162 billion last year, almost equaling 2019’s record $166 billion, per the Infrastructure Investor database. By contrast, stocks and bond funds both endured investor flight in 2022.

Steven Wittwer, group head of infrastructure at Duff & Phelps Investment Management Co., ticks off all the ways infrastructure investments have supplanted bonds in desirability. The income they generate “is predictable,” he says. What’s more, they have little or no competition. Electric utilities are local monopolies. Some infrastructure endeavors are privately run government concessions, such as toll roads, or private enterprises with long-term contracts—cell towers, for instance. But they all “have visibility” about their financial conditions and built-in price increases, to the benefit of investors, Wittwer adds.

While these infra categories do different things, they have a common thread: They serve ongoing needs. People won’t stop requiring water, electricity, transportation, etc., even in the harshest recession. Given demographic trends, humanity will require more of what these kinds of organizations are selling. Plus, for investors, risk is low. “These are tangible services that are resilient to downturns,” notes Steve Farrell, co-CIO of Summit Global Investments, an investment adviser.

The momentum for infra is mounting. The giant infra bill that Congress passed in 2021 will devote $1.2 billion to building out or repairing the nation’s physical plant, ranging from roads to sewers to transit. Lots of non-government capital from institutional investors is expected to follow. The World Pensions Council, a research group, predicts that U.S. pension programs will surpass the federal government’s outlay in coming years, by a 2-to-1 margin. A lot has to be done. The U.S. began constructing the interstate highway system in 1955, and now those vital arteries are in dire need of an overhaul. Funding is likely to come from many sources, including institutional investors, states, localities and the federal government.

And does this alternative investment ever have fans. Take the New Mexico State Investment Council, which began amassing a position in infrastructure in 2017. As the fund explained in its latest investment plan, infra and other real assets such as farmland “are expected to be advantaged over equities and bonds in an economic and financial market environment where growth is a little slower than average and inflation and interest rates are rising.”

“We really like the cash flow of infrastructure,” says NMSIC CIO Robert “Vince” Smith. The NMSIC owns 48 infra funds, totaling around $3 billion, according to Infrastructure Investor’s database. That’s around 8% of the New Mexico program’s assets under management. Its biggest commitment is to Brookfield Asset Management funds (seven), worth some $775 million. Returns range from 8% to 11%, Smith indicates.

Allocators also like that toll roads, for instance, generate about 10% yearly. The California Public Employees’ Retirement System in 2016 bought a 10% portion of the Indiana East-West Toll Road, known as “the Main Street of the Midwest,” that links Chicago with the Ohio Turnpike.

Institutional investors’ interest in infrastructure is hardly new. What’s different is a widespread perception that stocks and bonds won’t deliver in the future as they have in the past. With that in mind, physical assets with solid, dependable cash flows look like a very enticing alternative.

Public or Private Investments?

A lot of the best opportunities for appreciation are in non-publicly-traded partnerships, such as the funds Brookfield and its ilk run. They are immune from market gyrations, and while they often take on lots of debt, projected cash flow seldom has any problem servicing the interest costs. Reassuringly, most of the debt is investment-grade. Meanwhile, these funds tend to pay investors handsome dividends over their terms, which can stretch to seven years or more.

The infra companies with stocks have suffered in price terms along with the rest of the world’s equity issuers recently; in fact, even more so, as the early pandemic hit them especially hard—and then sexy tech stocks shot up (for a while), leaving boring infrastructure stocks in the dirt.

The S&P Global Infrastructure Index is down 0.23% for 2023 through March 24, as compared with the broader market index, which has gained just less than 3%. Over 10 years, the infra benchmark has gained 2.7% annually, while the S&P 500 has advanced 11.7%. Electric utilities, of course, are habitual slow growers. And the fortunes of energy—a big chunk of infra—have been volatile. On the plus side, public infrastructure stocks’ beta is 0.5, which means they are not very sensitive to the general market’s gyrations.

For investors, public infra offerings make up for this shortfall partly by delivering lush dividends. Example: Enterprise Products Partners, a pipeline company specializing in natural gas and oil, has seen its price grow very little in recent years. A master limited partnership (i.e., it is publicly traded), EPP sports a 7.7% annual dividend. (The S&P 500’s average payout is 1.74%.) “It’s low-risk, like a utility,” says Jay Hatfield, CEO of Infrastructure Capital Advisors asset managers.

The pipeline company, which has generated expanding revenue for years, has increased its dividends more than 75 times since going public in 1998. EPP recently unveiled an initiative to ship carbon dioxide through its pipelines, from wellheads to permanent storage sites, so this greenhouse gas does not escape into the atmosphere.

So what pays the best, publicly or privately listed infra investments?

They are close, according to a study by real assets investment manager Cohen & Steers. From 2004 through 2021, public infra returned 9.8% and private 9.4%.

Inflation, certainly, is the enemy of traditional asset classes, with fixed income suffering more than equities. The same study found that infrastructure holdings, whether public or private, actually gained a little amid inflation surges. From January 1979 through September 2022, inflation spikes saw infra returns improving an average of 1.08%, while stocks lost 0.24% and bonds lost 2.58%.

What to Invest In, From Water to Wattage

A growing world demands more infrastructure—that’s the abiding philosophy of investors in this space. For instance, electricity use will increase in coming years as more and more electric vehicles take to the road, says Cliff Corso, president and CIO of Advisors Asset Management.

Electricity from renewable sources, in particular, appears to have a bright future, both for established companies and newbies in solar- and wind-power generation. Among the old guard utilities that should do well, analysts say, is Duke Energy, which mostly serves the growing Southeast region of the U.S. and has ambitious energy transition initiatives, such as a 50% carbon reduction by 2030. With annual stock growth averaging around 4% over the past five years, its is a slow and steady investment, with a nice 4% dividend.

Sure, public utilities can run into trouble. Witness the hard times the Pacific Gas and Electric Co. has endured, as it took the blame for several California wildfires since 2017 and paid out millions in damages to people whose homes were lost. Over the past five years, PG&E shed three-quarters of its valuation and went through bankruptcy, exiting Chapter 11 in 2020. This company is an outlier among large utilities, though.

Other opportunities: Clean water will be in large demand as once-impoverished nations develop, so overseas water investments stand to do well, goes the argument. Still, good investment targets exist for this space domestically. American Water Works, the largest U.S. water utility, which has been on an acquisition binge of smaller operators, has regularly beaten analysts’ estimates on revenue and earnings.

Rapid growth is the story for more newfangled infrastructure. Wireless communications offer a case in point. By BCC Research’s estimate revenue of $65.2 billion in 2021 will expand to $130.6 billion by 2026, growing around 15% yearly.

In the U.S., a duopoly of American Tower and Crown Castle control much of the action. Whatever company has the franchise for a municipality usually has zero competition. Local governments don’t want a plethora of cell towers in town, so carriers on the order of Verizon and T-Mobile will share a single tower, explains Duff & Phelps’ Wittwer. The result, he adds: Cell tower investment “returns are in the high teens.”

There are different stages of site development for infrastructure organizations; thus, investors should assess timetables for new expansions. The most risky stage is what infra folks call “greenfield.” That’s when a project is being planned and construction started. Local political or environmentally minded opposition can erupt at this phase, delaying or ending the project. The “brownfield” stage, when a project is up and running—and generating revenue—is far less risky.

To no surprise, greenfield backers, who take the highest risk, stand to reap the richest rewards, in the 20% to 30% return bracket, versus low to high teens for brownfield investors, Advisors Asset Management’s Corso says.

“TINA is retired,” Corso declares, referring to the erstwhile slogan “there is no alternative” to stocks. The same could be said about bonds, which used to be the refuge of choice, until they weren’t. Enter infrastructure to claim the latest rounds of investment dollars.