Infrastructure and Inflation Outlook 2015

Key points:

1. We forecast inflation over the next five years will average between 2.30%-2.50% per annum
2. The combined impact of weaker economic growth and a weaker Australian dollar overall are neutral to Sydney Airport’s credit.
3. If you would like to increase your allocation to infrastructure but are concerned about a low inflation outlook, then nominal infrastructure bonds such as Adani Abbot Point or Plenary provide an exposure to infrastructure through high yielding nominal bonds.

Infrastructure outlook

From a bondholder’s perspective, the infrastructure sector provides exposure to steady, long term, inflation linked returns. This makes infrastructure an appealing sector for bondholders. And in the current volatile environment, we believe the case for allocating a portion of your fixed income portfolio to infrastructure is even stronger, given the quality and stability of cash flows which support bondholder returns.

While economic growth is expected to be muted in Australia, we believe the performance of Public private partnership (PPP) assets will remain largely unaffected by macroeconomic conditions and will continue to generate steady income returns for bondholders. PPP assets rely on contracted government revenues to pay interest (coupons) on their bonds, and so their performance is heavily tied to the credit ratings of the governments which pay for these PPP assets. With the Australian economy in for an extended challenging period, there remains a residual risk that the credit ratings of Australian governments could be impacted. At this stage there are no indications that Australian government credit ratings are at risk.

While weaker prospects for economic growth will moderate Australian overseas travel, the weaker Australian dollar will make Australia a more attractive destination for incoming overseas tourists. We therefore think that the combined impact of weaker economic growth and a weaker Australian dollar will be overall neutral to Sydney Airport’s credit.

As we will outline further below, if you would like to increase your allocation to infrastructure but are concerned about a low inflation outlook, then we would recommend nominal infrastructure bonds such as Adani Abbot Point or Plenary which provide an exposure to infrastructure through high yielding nominal bonds.

Inflation expectations

With the recent disappointing GDP figures and weaker outlook for economic growth in Australia, we have seen a softening in inflation expectations. Breakeven inflation is a commonly used guide to the market’s forecast of Australian CPI, which compares the yield of an Australian government nominal bond against a similarly dated Australian government capital indexed bond. The ‘spread’ between the two yields is the implied level of future CPI inflation being priced into bond yields.

The chart below shows two historical measures of breakeven inflation – one comparing the yield on the May 2021 nominal government bond to the August 2020 capital indexed bond, and the other comparing the April 2020 nominal bond against the same capital indexed bond. Given the remaining term of the bonds, we can infer that this is the market’s view of average inflation over the next five years. Following the recent disappointing GDP figures, breakeven inflation levels have fallen to between 1.89% and 2.03%, the lowest levels seen since a sharp but temporary fall during the GFC.

Source: Bloomberg

We think that the market reaction to the recent GDP figures has been an overshoot and as such the current breakeven inflation level is under-forecasting future CPI levels. We expect inflation over the next five years will average between 2.30%-2.50% per annum. However, if you believe the market has priced in future inflation levels correctly, and that inflation is likely to be closer to 2.00% over the medium term, then it is worth considering switching from inflation linked bonds into nominal bonds.

For investors who would prefer to hold nominal bonds but who want exposure to the infrastructure sector, we would particularly recommend the Adani Abbot Point 2020 nominal bond as a sound investment pick for 2015. The bond continues to be one of our highest yielding investment grade bonds, supported by long term, take or pay contracted revenues.

Copyright The contents of this document are copyright. Other than under the Copyright Act 1968 (Cth), no part of it may be reproduced or distributed to a third party without FIIG’s prior written permission other than to the recipient’s accountants, tax advisors and lawyers for the purpose of the recipient obtaining advice prior to making any investment decision. FIIG asserts all of its intellectual property rights in relation to this document and reserves its rights to prosecute for breaches of those rights.

Disclaimer Certain statements contained in the information may be statements of future expectations and other forward-looking statements. These statements involve subjective judgement and analysis and may be based on third party sources and are subject to significant known and unknown uncertainties, risks and contingencies outside the control of the company which may cause actual results to vary materially from those expressed or implied by these forward looking statements. Forward-looking statements contained in the information regarding past trends or activities should not be taken as a representation that such trends or activities will continue in the future. You should not place undue reliance on forward-looking statements, which speak only as of the date of this report. Opinions expressed are present opinions only and are subject to change without further notice.

No representation or warranty is given as to the accuracy or completeness of the information contained herein. There is no obligation to update, modify or amend the information or to otherwise notify the recipient if information, opinion, projection, forward-looking statement, forecast or estimate set forth herein, changes or subsequently becomes inaccurate.

FIIG shall not have any liability, contingent or otherwise, to any user of the information or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the information. In no event will FIIG be liable for any special, indirect, incidental or consequential damages which may be incurred or experienced on account of the user using information even if it has been advised of the possibility of such damages.

FIIG provides general financial product advice only. As a result, this document, and any information or advice, has been provided by FIIG without taking account of your objectives, financial situation and needs. Because of this, you should, before acting on any advice from FIIG, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. If this document, or any advice, relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a product disclosure statement relating to the product and consider the statement before making any decision about whether to acquire the product. Neither FIIG, nor any of its directors, authorised representatives, employees, or agents, makes any representation or warranty as to the reliability, accuracy, or completeness, of this document or any advice. Nor do they accept any liability or responsibility arising in any way (including negligence) for errors in, or omissions from, this document or advice. Any reference to credit ratings of companies, entities or financial products must only be relied upon by a ‘wholesale client’ as that term is defined in section 761G of the Corporations Act 2001 (Cth). FIIG strongly recommends that you seek independent accounting, financial, taxation, and legal advice, tailored to your specific objectives, financial situation or needs, prior to making any investment decision. FIIG does not make a market in the securities or products that may be referred to in this document. A copy of FIIG’s current Financial Services Guide is available at www.fiig.com.au/fsg.

An investment in notes or corporate bonds should not be compared to a bank deposit. Notes and corporate bonds have a greater risk of loss of some or all of an investor’s capital when compared to bank deposits. Past performance of any product described on any communication from FIIG is not a reliable indication of future performance. Forecasts contained in this document are predictive in character and based on assumptions such as a 2.5% p.a. assumed rate of inflation, foreign exchange rates or forward interest rate curves generally available at the time and no reliance should be placed on the accuracy of any forecast information. The actual results may differ substantially from the forecasts and are subject to change without further notice. FIIG is not licensed to provide foreign exchange hedging or deal in foreign exchange contracts services. The information in this document is strictly confidential. If you are not the intended recipient of the information contained in this document, you may not disclose or use the information in any way. No liability is accepted for any unauthorised use of the information contained in this document. FIIG is the owner of the copyright material in this document unless otherwise specified.

The FIIG research analyst certifies that any views expressed in this document accurately reflect their views about the companies and financial products referred to in this document and that their remuneration is not directly or indirectly related to the views of the research analyst. This document is not available for distribution outside Australia and New Zealand and may not be passed on to any third party without the prior written consent of FIIG. FIIG, its directors and employees and related parties may have an interest in the company and any securities issued by the company and earn fees or revenue in relation to dealing in those securities.