The core infrastructure – which is defined as those assets that focus on essential services underpinned by regulatory frameworks or long-term contracts with high-quality counterparties – held up well during the pandemic. Partially due to its relatively low margin of error, long-term income visibility, and high EBITDA margins, it’s becoming an increasingly important competent within both institutional and private banking investors’ portfolios. 

Amid the rising inflation environment, J.P. Morgan Asset Management’s Shawn Khazzam, Head of Alternatives Distribution, Asia Pacific and Gilly Zimmer, Investment Specialist, Infrastructure Investments Group discussed about the role of infrastructure in investors’ portfolios and the sub-sectors that tend to benefit from the rising inflation and volatility environment.

Shawn Khazzam: Gilly, let’s take a step back and talk a little bit about the role of core infrastructure in a portfolio. For example, I have a lot of discussions with clients around the vehicles that we can have for infrastructure funds, such as open-ended and closed-ended funds. How does all that relate to the role of infrastructure in the portfolio, and how do you think about the two?

Gilly Zimmer: Ultimately, how I believe the role of infrastructure in the portfolio is two-fold: Opportunities for consistent income and managing downside risks in a crisis. We recently saw that in 2020. If you were in core, such as regulated utilities and contracted businesses, you would have likely seen income last year with reduced volatility.

For open-ended funds, there are no “blind pools”. For example, clients may have full transparency of what they’re buying into ahead of time, and the liquidity features of them are more attractive. For close-ended funds, the target IRRs tend to be higher although the liquidity and transparency features may be less favorable. Thus it really depends on clients’ risk return appetite. At J.P. Morgan Asset Management, we believe there is a strong core and foundational element in open-ended, while what we can do in terms of closed-ended tends to be more tactical.

Shawn Khazzam: When you talk about core infrastructure having opportunities for consistent cash flow, it sounds a lot like fixed income. How does core private infrastructure complement fixed income exposure in a portfolio? 

Gilly Zimmer: When you’re looking at role of fixed income exposure in a portfolio, I would focus on core as opposed to value-added core plus. I’ve seen a lot of investors move down the risk curve by replacing equities with infrastructure, as they want to reduce volatility that they’re seeing in the public markets. After all, it is about the portfolio that you currently have and what is your additional risk appetite.

Shawn Khazzam: One of the most frequently asked questions coming up in client conversations is on the US infrastructure package. What are your views on the implications of the stimulus plan on core infrastructure?

Gilly Zimmer: What the infrastructure bill does at least for core is that it raises the subject on infrastructure by highlighting the importance of improving infrastructure within the US and the importance of the asset class relative to other areas of your portfolio.

When you are thinking about improving roads or bridges or some of the things coming out of the infrastructure bill, they tend to be more greenfield/development, and the income tends to be delayed until you finish the construction or development. However, it will increase the potential for medium and longer-term pipeline for core.

Shawn Khazzam: Another topical item on investors’ minds is inflation. Infrastructure is widely known to provide some sort of inflation hedging. Can you explain what sectors of the infrastructure space tend to benefit more in a regime of inflation and rising rates? 

Gilly Zimmer: Taking utilities as an example, such as our water or electricity bill, if there is inflation in the environment, it tends to increase that bill. It’s not going to be significant, but it tends to be not a significant delay, either. From utilities’ standpoint, we would say through frameworks and regulatory structures, revenues tend to rise quicker than costs.

The other area that tends to work well is transport investments. If you think about airports and airplane tickets, as well as purchasing items at the airport, when there is inflation in the environment, your airport tickets or your airport purchases are likely to be more expensive. If inflation only sticks around for a few years, it’s unlikely a key risk. But if it stays around for 10 to 20 years, then it’s structural, and that’s when you’ll see the real benefits come out of investing in the asset class.

Shawn Khazzam: Infrastructure fundraising continues to pick up; with so much capital coming into the space, are valuations getting stretched on core assets? Connected to this, how sustainable is the cash yield of this asset class? 

Gilly Zimmer: If I look at the risk premium of core infrastructure over bond or interest rates in the last 20 to 25 years, it’s been relatively consistent between 6% to 8%¹. I would say the premium has been strong and seems proportional for the risk you’re taking when it comes to the core.

^{Source: Bloomberg, J.P. Morgan Asset Management. Discount rates are estimated. Equity risk premia represent the difference between the core infrastructure discount rate and the geographically weighted annual average yields. Data as of Q1 2021}

We are starting to see prices go up and returns come down in certain sectors, particularly renewables in the US. Yet, if fund managers have a strategic way in putting capital to work, it’s possible to maintain that risk premium for investors.

The income is sustainable as these are essential services and they are inelastic. For example,  people tend to pay these bills much quicker than their credit card bills, as they don’t want the water or electricity turned off. Similarly, with or without a job, people are not going to drink water or use electricity differently. So that income component, which stood up during COVID, which also stood up during the global financial crisis, is fairly sustainable.

Shawn Khazzam: What’s also very interesting for our investors to think about is how core infrastructure plays into the energy transition. When it comes to investments, how do you think about exclusion or integration?

Gilly Zimmer: We don’t take an exclusionary approach to investments when we think about acquisitions, as these infrastructure investments are critical and essential, and they need to be managed.

The role of a natural gas business may be very different in 20 years, but its essentiality can’t be argued. What we don’t want to see is critical businesses ending up in hands that don’t focus on sustainability, that aren’t thinking about a lower carbon world, that aren’t thinking about what they can do today in order for this business to be driving more success and more revenues in the long term.

Shawn Khazzam: Can you tell us about your view on the outlook for the asset class?²

Gilly Zimmer: I’m a big believer of this asset class, and I think it can be considered as a foundation of institutional and non-institutional portfolios. I’ve seen investors in Asia, North America and Europe starting to invest in infrastructure more and more. As Investors seek opportunities for income and managing downside risks, there’s likely more support for this asset class going forward.