19 November 2020
Real assets, including real estate and infrastructure, have become an increasingly important component of a multi-asset portfolio. Commercial real estate was first introduced to institutional investment portfolios in the 1970s, while infrastructure earned a place across investor portfolios in the '90s, emerging as a stand-alone asset class. While diversification is one of the main drivers for including real assets in a portfolio, we believe there is also another key benefit to maintaining exposure to real assets: sustainable income.
The search for income grows harder
Investors looking for sustainable income sources face greater challenges in accessing them than ever before. These include historically low fixed income yields and extremely accommodative monetary policy undertaken by central banks. Moreover, this easy monetary policy environment will likely keep yields on government bonds in the zero (or close to it) range for years to come.
What does lower interest rates mean in the context of a portfolio? Simply put, this suggests that fixed income returns are likely to be less going forward. In addition, investors seeking sustainable income will also need their income stream to last longer, in order to offset longevity risk.
Amid this backdrop, we believe that real assets - specifically, infrastructure and real estate, deserve to be considered as integral components of portfolios for investors where income is the desired outcome.
Insurers looking for increased yield can also achieve a higher, more contractual income than their traditional credit holdings, through investing in private debt which encapsulates senior lending to corporates, as well as real estate debt and infrastructure debt when attractive opportunities present themselves.
Income generation in real assets
In both core real estate and infrastructure strategies, a significant proportion of the long-term total return is derived from current income generated by the underlying assets.
In the case of real estate, the income stream is derived from contractual rent payments associated with tenant leases. Over time, the income stream may increase by either natural organic growth or value-added improvements to individual properties, such as refurbishment and technological / environmental upgrades. For infrastructure, the income stream is associated with long-duration assets that exhibit predictable and resilient cash flows. The resiliency of cash flows attached to infrastructure assets can be attributed to the following: essential nature of the service provided, structural growth, high barriers to entry and strong pricing power.
Similar to real estate, infrastructure asset income streams grow over time due to increasing volumes - i.e., increased traffic on a toll road - and operational improvements designed to enhance revenues - such as shopping
The enhanced income-generating characteristics of infrastructure and real estate investments over the past decade, relative to government bonds, is highlighted in the charts below. These charts show the spread of their respective dividend yields relative to U.S. 10-year Treasury bond yields over the 10-year period ending 30 September 2020.
In the case of infrastructure, the average spread to U.S. 10-year bond yields over the 10-year period is 2.07%. As of 30 September 2020, it is 3.48%.
In the case of real estate, the average spread to U.S. 10-year bond yields over this same period is 1.67%. As of 30 September 2020, it is 3.69%.
As the charts demonstrate, both infrastructure and real estate provided a superior level of income relative to government bonds in the past ten years - a performance which we believe will continue this decade.
Maintaining purchasing power
There is also another key benefit that we believe real assets provide, relative to nominal government bonds: protection against inflation. Why?
This is because inflation negatively impacts the real level of income (bond yield minus inflation) associated with nominal bonds. In contrast, real assets, due to their unique characteristics, provide investors with an income stream that is generally protected from the impacts of rising inflation - good news due to the importance of income sustainability. We believe this trait will serve investors well in the coming years, given the potential for inflationary forces, primarily due to the massive amounts of fiscal and monetary stimulus that governments and central banks have injected into the global economy in light of the COVID-19-driven recession.
Most infrastructure assets have an explicit link to inflation through regulation, concession agreements or contracts. This is also a reflection of the fact that, as previously note, many infrastructure assets operate in monopoly-like competitive positions and enjoy inelastic demand patterns. Namely, they can increase prices without destroying demand.
Real estate has been identified as having a long-term relationship with inflation. Over the long term, real estate may provide some protection against inflation, because real estate revenue - which is derived from periodically resetting contractual rental payments - will adjust to changing external market conditions, such as rising price levels. Furthermore, in an inflationary environment, the replacement cost of real estate increases, therefore boosting the value of existing buildings. Replacement cost is the final cost to re-build at current market prices, and incorporates such factors as land value, labour and materials - i.e., lumber and steel.
Private debt – Another source of income
Over the past 10 years, private debt as an asset class has grown significantly in an absolute sense - but still has significant room to grow when compared against the size of the traditional debt markets globally. The reduced level of lending by banks post the Global Financial Crisis allowed private pools of capital to fill the gap in lending to corporates, real estate business and infrastructure businesses. Private debt opportunities can be structured in many ways and for numerous reasons, including the following:
- Allow private equity firms to raise capital for buy outs;
- Direct loans to corporates which are typically senior in nature;
- Subordinated loans including second lien, mezzanine and hold company tranches
Insurers should consider all flavours of the private debt space, with a strong core anchor holding in the senior lending space, which is positioned the top of the debt capital stack and the last to be impacted in an adverse scenario. Furthermore, there is a level of diversification available from the space. This is due to many of the borrowing companies not being active in the bond issuance space. These loans are typically floating rate and attractive to investors who want to limit risk to a rising rate environment that a jump in inflation could cause.
The bottom line
In the current economic and financial market environment, to generate income we believe increased allocations toward real estate, infrastructure and private debt may be beneficial. Aside from their attractive income characteristics and their ability to provide a degree of inflation protection, we also see many other potential ancillary benefits, including:
- Portfolio diversification
- Attractive valuations, relative to global equities
- Excess return generation (alpha) through active management
- Exposure to structural themes that will likely play an increasingly important role in the 21st century economy - i.e., growth in infrastructure spending, increased data usage, e-commerce, logistics and renewable energy sources
Many insurers are increasingly seeking investments that have the potential to provide superior and sustainable levels of income relative to traditional fixed income investments. In an environment characterised by both low-to-negative government bond yields and unprecedented monetary and fiscal stimulus, we expect the cash flows associated with real assets and private debt income streams to become even more sought-after.
Unless otherwise specified, Russell Investments is the source of all data. All information contained in this material is current at the time of issue and, to the best of our knowledge, accurate. Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested.
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