Introduction

In recent months investors have once again turned their attention to inflation risks. Across most developed markets, the combined impact of loose monetary and fiscal policies through the COVID lockdowns, followed by rising demand but persistent supply chain disruptions with the easing of lockdowns produced inflationary pressures that were generally considered to be within investor expectations. However, the invasion of Ukraine by Russia has placed additional pressure and uncertainty on commodities, energy, and power markets.

Investors are now reviewing the long-held status of infrastructure as an inflation-protected asset class, and the potential impact on future portfolio returns. Similarly, over the past 10 years, the definition of “infrastructure” has broadened as new industries and sectors such as digital infrastructure have joined the available investment universe. How have the mechanics of revenue and cost recovery affected infrastructure's continued ability to provide inflation protection?

Infrastructure is generally considered a low-risk, long-term asset class. Supported by long-term, stable, and often inflation-protected cash flows, infrastructure assets have been able to use substantial leverage to enhance investor returns. However, this leverage also exposes assets to related inflation and interest rate risks.

In this Stafford Diary, we review the mechanisms that provide inflation protection to infrastructure returns. We do this in two parts. Firstly, we look at the underlying mechanisms of inflation protection across the various infrastructure sectors at the revenue, cost, and valuation level. Secondly, we review the recent analysis of data from managers in our own portfolio to test our expectations against reality.

We also review the impact of changes in interest rates. We look at this from two perspectives. Firstly, we assess their impact on the asset’s cash flows and the consequences this will have on operating performance and distributions to investors. Secondly, we review the influence of changing rates on valuations via movements in the discount rate upon which valuations are struck.

In reviewing these mechanisms across various infrastructure sectors, we acknowledge that these mechanisms are complex, and often tie to factors such as each an asset's capital structure, local regulatory issues, and the competitive environment. We look at a few examples where Stafford’s due diligence has applied sensitivity analysis to individual assets, arriving at a total fund level exposure to inflation. Additionally, inflation movements may also lead to changes in investors’ asset allocation decisions which will potentially also have an impact on secondary market valuations for these assets.