The Pendulum Swings Toward Real Assets
For many institutional investors, real assets have offered long-term strategic viability within diversified portfolios. With current economic and market fundamentals underpinning the asset class, it may be time for investors to consider investing, or increasing their allocation, in this space.
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“We believe that real assets can play a long-term strategic role in the diversified portfolios of a wide range of institutional investors from defined benefit plans to endowments and foundations to defined contribution plans,” said Rob Guiliano, senior portfolio manager at State Street Global Advisors’ Investment Solutions Group. “The issue today is that we’ve gone through an extended period of declining and low inflation where traditional asset classes have done extremely well. The conversation we’re now having with clients is that expectations for equities and bonds have come down dramatically, while inflation could be structurally higher. So, what are the implications for your portfolio? Where is the potential return going to come from? We suggest looking to other assets and asset classes, particularly real assets, to help complement traditional equity and bond exposures.”
Real assets may play a complementary role in a diversified portfolio, both for hedging risk and adding to return, according to Louis Basque, vice president and portfolio strategist at State Street’s Investment Solutions Group.
“When we look at inflation-hedging characteristics, real assets like commodities and natural resources have significant inflation beta, a higher beta than equities. To a lesser degree, infrastructure and real estate may also provide a beneficial inflation hedge. All four sub-asset classes may provide attractive inflation-hedging characteristics across different phases of the business cycle,” said Basque. (See chart.)
“Some real assets can offer varying sources of return, whether that is dividend income from some of the equity components, such as global natural resource and infrastructure stocks or real estate investment trusts; price return, if we’re talking about commodities; or coupon and stable income, if we’re looking specifically at Treasury Inflation-Protection Securities,” he said. “In terms of strategic allocation, investors are likely to always maintain some real asset exposure, but we suggest this may be a moment to reassess the level of strategic allocation based on the current economic and market outlook,” Basque said.
Shift In Underlying Drivers
In addition to the inflation rationale that supports a fresh look at real assets, Nick Langley, managing director and portfolio manager at ClearBridge Investments, said that real assets may help correct a portfolio imbalance that has been developing over decades.
“Besides inflation protection, a secondary and longer-term issue is the balance between real assets and financial assets, which has become very skewed towards financial assets,” Langley said. “That pendulum may start to swing back toward real assets, with decarbonization and climate change being key triggers.”
According to Langley, the financialization of assets has been driven by the steady decline in the cost of capital over the past three decades. But in a world where the cost of capital is stable or even rising, and the world is pushing to decarbonize the economy, there’s an argument for higher utilization of real assets. “The only way to fight climate change is through the use of real assets,” Langley said. “If you think about timber or land and agricultural commodities, we need to decarbonize there. With real estate, there’s a massive retrofitting process that’s going to have to get underway. And one could expect broad impacts across infrastructure, which is transportation and energy, and so on. This long-term trend centers around the real physical world and permanently adapting the way we live. It would be extremely naive to think it will be all wrapped up by the current 2050 target,” Langley said, referencing the Paris Agreement goal of net-zero greenhouse gas emissions by 2050.
Relative Value Versus Bonds
Langley, who manages a portfolio of infrastructure public equities, said that he believes the case for real assets overall and infrastructure, in particular, is further strengthened given current trends in real bond yields.
“In fixed-income markets, income is now at a level where you’re not being compensated for the risk around the capital value,” Langley said. “Moreover, the Federal Reserve and central banks around the world may be looking to keep a lid on nominal bond yields. With a real possibility for structurally higher inflation going forward, we see real bond yields being zero to negative for quite a while. By contrast, in a sector like utilities, allowed return on equity has been quite sticky, with regulators tending to be quite slow in adjusting allowed ROEs in response to falling bond yields.”
Broad public policy support for increasing the climate resilience of infrastructure assets should result in higher growth in asset bases, favorably regulated returns and inflation protection — all of which can provide solid support for the capital value of high-quality infrastructure assets over the coming decades.
“Given these trends, I would suggest that investors start thinking about moving some of their fixed-income exposure into infrastructure because it can deliver much higher income, with a potential capital upside from a growing asset base,” Langley said.
Flexibility of Private Credit
As fixed-income investors continue to chase yield in public markets, they may [instead] find more attractive risk-adjusted returns in higher-yielding infrastructure debt, said Dimitrios Papatheodorou, senior portfolio manager at HSBC Asset Management.
“This asset class can generate secure income streams with stronger returns, in the 10% to 12% range, and lower volatility than can be realized in public markets,” he said. (See chart on page 5.) “In addition, infrastructure debt has typically demonstrated a strong resilience in the face of economic cycles and shocks. According to Moody’s, the likelihood of defaults, and subsequent losses in the event of defaults, is materially lower for private infrastructure debt relative to equally-rated corporate debt.” The nature of the underlying assets and the associated strong contractual frameworks support this resilience, he said, noting that the investment selection process for these assets is also critical.
Papatheodorou said that private credit is quite flexible in terms of where it can sit in the debt capital structure — anywhere between senior secured credit down to secured subordinated debt — with a clear route to enforcement if needed.
“In high yield infrastructure, mid-cap private debt transactions tend to be less contested by the capital markets,” he said. “The transactions can be smaller, below $200 million, and are often unrated, creating a more dynamic market where lenders have the ability to engage more closely with the borrowers to structure deals that optimize the benefits for both borrower and investor.” Mid-cap lenders and investors are in a better negotiating position when compared to large syndication deals run by investment banks, where each investor may represent a small piece of the pie and can be distanced from the actual borrower.
“Mid-cap deals can provide investors strong flexibility with a highly-diversified set of opportunities across the globe and across the ratings spectrum — whether participating in core infrastructure sectors (utilities, airports, ports, toll road, renewables), in fast-growing digital infrastructure sectors (data centers, fiber networks, cell towers) and in social infrastructure (housing projects, healthcare). That is why global mid-cap private credit strategies that can invest across the capital structure in both senior and junior tranches tend to achieve higher yields for similar levels of risk,” he said.
Inflation: Is It Different This Time?
“We have been conditioned, over many decades, to expect low or declining inflation, because we have not experienced sustained higher inflation since the 1980s,” said State Street’s Guiliano. “So the expectation is that anytime we see a bump or a blip of higher inflation, it will revert back down. But when that expectation is called into question, as it is today, it creates a very tenuous time when a new calculus can lead to very different actions by investors or consumers. The punchline in this story is that inflation may not revert, as in the past, and that there’s a decent chance it may be different this time.”
“Our base case is that inflation will be structurally higher going forward,” said ClearBridge’s Langley. “We do see some transient supply chain interruptions that will likely eventually pass through the system. But, coming out of the pandemic, we’re also seeing labor’s share of GDP increase, driven by a range of financial and social factors. The Fed’s inflation targeting has let the balance shift slightly towards employment, suggesting that labor markets might run a little hotter, with higher wage inflation going forward.”
“Wages are a good example of how shorter-term pressures can become ingrained,” said State Street’s Basque. “As new employees enter the workforce at higher wages, due in part to the employment shortages we’ve seen, it doesn’t necessarily immediately impact the overall level of wages. But as employees renegotiate work agreements, or change jobs in pursuit of higher salaries, we can see an adjustment to wages that can extend far beyond just short-term transitory adjustments. (See chart.) The big question is whether developed economies can continue to run with historically low unemployment levels and little upward wage pressure. The pandemic may be a trigger that changes that relationship in a durable way.
Structural Impacts Are Underway
“Some corporations are looking to fix supply-chain issues by moving production back to higher-cost locations,” said Basque. “Energy prices may remain elevated, as there’s an effort by energy companies to be more disciplined and profitable in the face of higher demand. In another example, one can see inflationary pressure in rising rents, which have increased as home ownership has become less affordable. Delayed impact on rent costs may yet have a large impact on inflation. Such shorter-term transient factors can have long-term structural effects, even if they take longer to adjust. In many cases, these kinds of changes may look transient but be sticky in their long-term impact on prices.”
According to ClearBridge’s Langley, the elephant in the room, which is being missed by many investors and policymakers, is the impact of climate change, which has raised decarbonization to the top of the public policy priority list in many countries.
“A big part of the transition cost is going to come from stranded assets,” he said.
“Everybody feels good when a coal or nuclear plant shuts down early, but those operators still get to recoup those regulated costs from ratepayers, even as they are building new capacity. So, in essence, ratepayers are paying twice for the same amount of capacity, once for the stranded asset and a second time for its replacement.”
There is also the growing pressure on consumer prices from carbon-pricing schemes. “By the mid-2020s, climate-and decarbonization-related inflation will start to find its way into inflation prints,” he said. “Carbon-pricing regimes are beginning to take hold around the world, with carbon prices ultimately finding their way into consumer prices over the next several decades.”
As an example, he pointed to the “Fit for 55” plan in the European Union that mandates European companies start paying for the carbon in their products beginning in 2026 — 10% in the first year, 20% in the second year and so on.
“Those costs are going to get passed through into wholesale and consumer prices,” Langley said. “Eventually the EU’s carbon border adjustment mechanism will result in all goods sold into Europe having some sort of carbon pricing embedded in them, and this is likely to be replicated across the world.”
Strategic View on Inflation Surprise
“In our view, it can be extremely hard in any market environment to determine whether or not we are about to enter, or have already entered, an environment of accelerating or persistently elevated inflation,” said State Street’s Basque. “This is definitely a risk that investors should acknowledge in their asset allocation.”
He pointed out that while a U.S. growth outlook may be supportive for stocks, and equity assets may provide a modest inflation hedge, equities tend to perform poorly in times of unexpected or high inflation. Given potentially higher inflation long-term, and short-term spikes along the way, he said that equities could be vulnerable, given their lofty valuations, and investors would do well to recognize that risk now.
“Oftentimes we start to react to changing market conditions with a delay, after an emerging trend has been underway for some time” said State Street’s Guiliano. “This is particularly true of inflation. But real assets often lead inflationary prints.” That is, returns of real assets begin rising in response to inflation before inflation shows up in official statistics.
“So it’s important for investors to have established that long-term strategic allocation beforehand. One can argue about how much that allocation should be at any given time, based on one’s views, but to realize its fullest potential, investors need to have made that real asset allocation before inflation hits elevated levels,” Guiliano said.
But the EM dollar-based credit market, particularly in Asia, should be a key focus for U.S. dollar-based institutional investors, according to Muaddi.
“While returns may be lower than they’ve been historically, the margin above Treasuries is largely unchanged,” he said. “So the real-return advantage, net of the risk-free rate, is almost as attractive as it’s ever been. We’re looking at the corporate high-yield market, companies that have been left behind and present both carry and capital appreciation opportunities.”
A New Era of Infrastructure Investment
In our view, infrastructure can be like a Swiss Army knife for a portfolio,” said ClearBridge’s Langley. “It can suit almost any investor objective, as investors generally gravitate toward the more yield-oriented side of infrastructure or toward a more balanced side that looks for capital growth and income. Infrastructure provides both of those types of strategies.”
On a risk-return basis with a medium to long-term investment horizon, infrastructure is likely to provide the best risk-adjusted return among sub-asset classes of real assets, he added.
“There are a few key reasons [for this], the first being inflation protection as most infrastructure companies get to increase their prices by inflation,” Langley said. (See graph on airport example.) “Second, the capital expenditure plans of infrastructure companies, because they are agreed upon with regulators, ensure predictable growth in the asset base and, therefore, growth in earnings, cash flows and dividends. Finally, and very importantly, this sector has phenomenal public policy support for at least the next couple of decades, enabling regulators to agree to attractive investor returns on a risk-adjusted basis.”
“Investors have been paying increasing attention to infrastructure over the past several years and this is one reason that we have seen considerable growth in the sector,” said Papatheodorou at HSBC. “However, beyond traditional allocations to investment-grade infrastructure debt, yielding about 4% today, and infrastructure equity, yielding between 9% to 15%, we are now seeing dedicated allocations to higher-yielding mid-cap private debt, which is yielding between 10% and 12%.”
“Sectors of particular focus for us — such as digital infrastructure and social infrastructure — continue to perform well,” said Papatheodorou. “Digital infrastructure assets have demonstrated accelerated growth, even in the midst of the pandemic. We are seeing significantly higher demand for data centers, which are offering positive performance, followed by several housing projects.”
An Evolving Opportunity Set
Papatheodorou emphasized that the infrastructure opportunity set is dynamic and continues to evolve over time. Investors need to stay open minded and current with the opportunities in the market, he said, adding that he takes an “expansive” view of the asset class.
“Things that may not be considered infrastructure today may be the essential infrastructure of tomorrow,” he said. “Construction bonds for disabled housing were not originally classified as infrastructure until investors validated the investment case. Data center assets can be considered a crossover with real estate, but they are a component of digital infrastructure at the same time. Energy storage, primarily in the form of large-scale battery storage, is beginning to be considered infrastructure today, as the world moves toward a decentralized grid and more renewable technologies, so that battery plants will soon become essential infrastructure.”
Of course, it takes expertise and connections to build a pipeline of strong deals in these areas, because opportunities are continually shifting in sectors and geographies across the capital structure.
“Take data centers in the United States. This market has seen a great deal of development over the last five years so that it is now closer to the asset-backed securities market. A lot of capital is chasing these transactions in the U.S.,” Papatheodorou said. “But it’s not the same in Europe. We are still able to find opportunities in European data centers that are fully operational at the junior level that provide yields in the high single digits. Social infrastructure is another example. In student housing projects, different levels of risk can be captured and compensated for in terms of a higher return including, for example, the potential in their construction or ramp-up phases as they start to become operational.”
Adopt The Quality Theme
In news headlines, there is a major focus on the quality theme. Infrastructure debt is no different, in that quality is an indicator of both return and risk-mitigation potential.
“Quality permeates all aspects of our business and is critical for success in private credit,” said Papatheodorou. “Our dedicated infrastructure investment platform is built to identify quality opportunities, in terms of resilient cash flow generation, sponsor strength, experienced management and advisors, along with market positioning. That’s the basis for delivering consistent, sustainable returns over the long run — not just in the current market environment, but throughout the business cycle. It’s the sustainability of returns, and all the factors that go into producing those returns, that form our definition of quality.”
“In infrastructure, the issue of quality is really twofold,” said ClearBridge’s Langley. “You need a quality company, but you’ve got this overlay of quality of environment, which can give long-term investors comfort that they’re going to achieve their expected returns over the long-term. And that second piece, built on a high level of public policy support, is critical. A lot of infrastructure is built to last 40 or 50 years. As an investor, if that’s the time frame for earning your return, you need to be certain that the legal, judicial and regulatory environments are going to be attractive over that entire timeframe.”
Differentiated From Real Estate
Langley also emphasized that investors need to have a clear understanding of the differences between infrastructure and real estate, which often sit side-by-side in the real asset portion of diversified portfolios. He said he believes that as the thematic for decarbonization and climate change takes hold and drives more public policy and expenditure, the impact on the two sectors could be quite distinct.
“There are many unknowns with respect to the large capital spend required to upgrade existing real estate,” he said. “In the post-pandemic era, it’s an open question whether there will be a market to provide a return on all the required capital for massive upgrades in areas like HVAC and insulation, given the uncertainty for sectors like office and retail. On the other hand, the path of infrastructure is quite clear, in terms of building renewable-energy generation, new electric transmission and grid infrastructure, recalibrating pipelines from natural gas to hydrogen. These costs are relatively well known, the technologies are available now, and regulators are acting on a public policy mandate to build new assets. There is a long-term predictability in infrastructure that isn’t the same for the property space.”
The Role of Esg
HSBC’s Papatheodorou said investor preferences for environmental, social and governance investing continue to develop and evolve. He said he believes that all three components are important, even if the governance component has traditionally received more emphasis in the infrastructure space.
“Investors are increasingly interested in several ESG issues,” he said. “Governance is critical in and of itself. But when you look at an asset as a business, we believe the projects that score well across all three ESG components have the necessary controls in place to deliver strong performance as an asset, as a part of a society, and in terms of adherence to the law.”
The more focus management has on all aspects of ESG, the less likely investors will endure negative surprises, Papatheodorou said. “For that reason, ESG is at the heart of how we operate in the private credit space within infrastructure. Every investment assessed is evaluated on ESG criteria and receives an internal ESG score that is weighed against other parameters as part of the overall investment decision. We also continue to monitor the ESG performance of each asset closely until the investment is fully realized,” he said.
“Our current investment mandates are not specifically focused on maximizing an ESG score or targeting specific ESG impacts,” he said. “But we will reject a transaction on the basis of a poor ESG assessment. For example, we reviewed a toll road in Latin America that would have passed through an area endangering native tribes. We also evaluated a social infrastructure project that was unacceptable in terms of equality and did not adhere to anti-discrimination laws. So our ESG analysis helps us flag certain risks that would eventually impact the long-term financial performance of an asset.”
At ClearBridge, said Langley, “ESG has always been a core part of infrastructure investing because the customers of these companies are very broad-based and are the voters in the community.” He added, “When you think about ESG, there’s a kind of social license to operate where the regulator represents the customer base in discussions around pricing and long-term development of capital expenditure plans, ensuring that these companies are operating efficiently and in the public interest. So the companies themselves need to have a skill set in ESG to deal effectively with regulators.”
The Role of Diversification in Real Assets
For most investors, a multi-strategy approach is the most effective way to access real assets,” said Guiliano at State Street. “One [term] that we like to use in describing this kind of strategy is that it can provide an ‘all-weather solution,’ bringing all the components and valuable characteristics of real assets together and [recognizing] the importance of real assets as a long-term strategic component of an investor’s portfolio.”
State Street’s team focuses on the largest, most liquid sectors of real assets, combining a range of indexed exposures into a broadly diversified portfolio. Such liquid components may provide an element of predictability to returns and deliver a great deal of transparency to investors, according to Guiliano.
This strategy also allows portfolio managers an element of active oversight.
“It’s possible, while using index components, to manage the method of gaining exposure and their respective weightings,” he said. “So while we focus on long-term strategic allocations, those can periodically be adjusted to an optimal asset mix using updated views on the index components.”
The passive approach to real assets sidesteps any need to invest in physical assets and enables global diversification without market-cap weighting schemes impinging on diversification.
“Many of the component indexes we utilize have sector allocations that are different from the sector’s actual market-cap weight,” Guiliano said. “We seek to ensure that sub-asset class exposures are properly diversified and not overly skewed towards one sector, such as energy, as they would be in a purely market-cap weighted portfolio.”
Diversification is just as important in sub-asset classes and direct investment as it is in diversified passive strategies.
“Diversification is critical across industry sectors, sub-sectors, positioning in the capital structure and even regulatory jurisdictions,” said HSBC’s Papatheodorou. “For example, certain U.S. shipping rules create natural monopolies for some companies. So one has to take care to diversify across a wide range of factors. For us, the common denominator across all sectors is the uniqueness of an asset in its market [and] the visibility of its income stream and cash flow generation which could be due to a monopolistic position or particularly strong contracts or leases in place.”
In fact, diversification is part of the appeal of real assets, both listed and unlisted.
“As we continue to invest in our infrastructure, the asset base grows, with regulators providing attractive returns to listed companies and their investors,” said ClearBridge’s Langley, whose focus is listed equities. “Power sector capital spending is projected to triple over the next decade. We’re seeing massive investments in digital communications infrastructure. Huge opportunities in energy storage. Enormous new and retrofit requirements for the transport sector. Moreover, very little of this activity is dependent on federal spending; it’s mostly happening at the state and local level, where private capital is involved. These kinds of listed assets enable investors to diversify by getting exposures that may not be available on the unlisted side.”
As examples, he cited EM airport stocks, cosmetics companies, where a portion of sales occurs in duty-free shops, and previously richly valued hospital and healthcare names. Yeung said he expects that if current trends in vaccination and economic recovery persist, rapid normalization over the next 12 to 18 months should provide a sizeable boost to many discounted names.
He also cautioned that not all high-growth, COVID-on stocks will continue on a tear in a COVID-off world. “We have a bucket we call dogs, bikes and boats,” he said. “These are companies that derived huge benefits in demand because we were all locked at home. It’s important to sort out which companies benefited from bursts of consumption that are one-offs and may not repeat in 2021 and 2022.”
Take A Total Portfolio View
While real assets may benefit the return side of the equation, especially in a world of low yields, the story that’s getting most of the attention today is the potential for structurally higher inflation. And here, real assets can suit the needs of a diverse spectrum of investors.
“Inflation risk is somewhat unique in that it affects every investor directly or indirectly, and it affects investors on both sides of their balance sheet,” said State Street’s Basque. “Inflation has a direct impact on expected returns from their assets, but it also directly impacts their liabilities, whether its pension beneficiary payments or, in the case of a foundation, it may be the price of education or scientific research.”
He pointed out that in some sectors of the economy, costs — such as for health care or education — actually increase at a higher rate than the core consumer price index would indicate. That, in turn, exacerbates the sensitivity to inflation for some groups, like retirees on fixed incomes who are heavy healthcare consumers.
“Many defined contribution plans provide equity and bond options and have historically excluded inflation-hedging assets,” said State Street’s Guiliano. “What I’ve observed over the last 10 years is a recognition and a willingness to try to bring in some inflation-hedging aspects — often through the use of TIPS or REITs — but, more recently, [via] multi-strategy funds that can be used on a stand-alone basis or fit into an automated glidepath approach, as in target-date funds. For defined benefit plans and other institutional investors, the liquidity features can offer a complement to more illiquid real asset approaches — like private natural resources and infrastructure or direct real estate — allowing investors to tactically adjust their total real asset exposure without disrupting those long-term commitments. It really works quite nicely with a wide variety of institutional investors.”