In Good Shape
The infrastructure market may experience substantial, possibly record-breaking growth in the coming year. As the investment landscape shifts, infrastructure investments are likely to continue presenting opportunities, fueled by technological advancements and rising demand for renewable energy.
Current patterns show an increase in interest in infrastructure equities and debt, driven by funding requirements for sustainable energy and digitalization.
Infrastructure – Equity
As interest rates along the curve continue to fall this year, as many analysts forecast, infrastructure company valuations are likely to rise significantly over the next few years. While the magnitude of the decline would be significant for investors to profit from infrastructure returns, reduced volatility might be equally supportive.
If yields fall on the premise of declining macroeconomic activity, the long end of the curve would come down further and those valuations could recover more than the current gap of approximately 40 basis points between the U.S. 2-year yield and the U.S. 10-year yield, according to ClearBridge Investments’ 2024 Infrastructure Outlook: Diversification Benefits Could Be Timely.
The global equity manager noted that the odds of a U.S. recession are currently around 15%, significantly lower than the predictions bandied about at the start of 2023, but believes a recession is still a “strong possibility,” and infrastructure provides a “significant and cheaper” diversifier within a portfolio with a “higher than normal” concentration in equity markets.
Given the growth possibilities of infrastructure companies, ClearBridge believes infrastructure is trading at historically attractive levels. The firm expects 2024 to begin with positive earnings revisions for infrastructure just as the broader equity markets begin to see negative earnings revisions.
Infrastructure benefits from three “megatrends” that provide a positive backdrop for investors, as well as a number of structural tailwinds, according to Capital Innovations’ co-founder and president Susan Dambekaln.
“We are laser like focused on infrastructure investments in the energy transition space (generation, transmission, network grid, storage, smart meters, battery charging stations, among other assets), digital transformation sector (companies that own, operate, and develop cellular tower, fiber network, satellite and data center assets) and enhancement of aging infrastructure assets (companies in the midstream energy, water utilities, gas utilities and transportation infrastructure sectors),” noted Dambekaln.
According to a Duff & Phelps analysis, 2020 was the only negative development in annual EBITDA growth during the last 20 years in infrastructure. The broader market, on the other hand, produced unpredictable results due to the financial crisis in 2008 and the pandemic. Infrastructure companies’ business models succeeded as expected and resisted difficult conditions.
Infrastructure – Debt
The areas with the greatest potential in the coming years are in power, energy infrastructure, communications, transportation & logistics, and social infrastructure & public-private partnerships, according to Capital Innovations.
Dambekaln believes that an appealing lending opportunity exists in digital infrastructure because of a “capital supply/demand mismatch”, which leads to price inefficiencies and greater capacity for specialized lenders to negotiate terms and conditions.
“Limited lending capital further exacerbates the capital inadequacies across the transportation, utilities, energy and power, digital, and social infrastructure sectors located predominantly in the US and other OECD countries,” said Dambekaln.
“Infrastructure debt has the ability to provide yield enhancement relative to public market fixed income, and resilient income with performance characteristics that are diversifying to other investment choices such as public bond markets and equities.”
Citing Moody’s Investors Service data, Dambekaln noted that the asset class has traditionally had a reduced probability of default and higher recovery rates when compared to rated corporate ratings. “We believe these characteristics make the sub investment-grade infrastructure debt universe an attractive area for institutional investors with long-term capital to find relative value and generate attractive risk adjusted returns.”
Opportunities Abound in ‘24
Overall, investors expect activity to pick up in 2024. KKR’s Raj Agrawal, partner and global head of infrastructure, wrote in the firm’s recent report, Looking to 2024 – How a Sweet Spot for Infrastructure Could Benefit Investors, “infrastructure assets with strong market positions, and contractual and regulatory protections provide both a downside cushion in the face of uncertain economic growth and a risk-mitigated, collateral-based way to buy exposure to secular trends with high growth potential.”
ClearBridge echoed the positive outlook, looking for increased return expectations in 2024. “On an internal rate of return basis — which we use as our primary valuation metric — we’re seeing a five-year compound annual return (total return basis in local currency) of roughly 16%, which is nearly 400 basis points above the historical average.”
It looks like infrastructure companies are in good shape in the new year. They’re converting higher bond rates into higher allowed returns, which is resulting in improved earnings profiles, and investors anticipate this trend to continue through 2024 and beyond.
