Tuesday 16 December 2014 by Alen Golubovic Legacy

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.

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