Infrastructure as an inflation hedge?

As my regular readers know, I am a big fan of infrastructure investments and as the chart below shows, I was right to be a fan for the last 20 years or so. With inflation running high, infrastructure investments are increasingly sold as a way to hedge portfolios against inflation. And here, I must intervene with a word of caution.

Performance of infrastructure investments vs. global equities and bonds

Source: Ravenhorst and Brounen (2022)

We have had more than a decade of low inflation and infrastructure investments performed really well, benefitting from a steady decline in discount rates that increased the net present value of future cash flows. Because infrastructure projects are very long infrastructure investments are very sensitive to changes in discount rates. The decline in discount rates has helped infrastructure investments generate strong returns over the last 20 years and supported these investments during periods of stress like the global financial crisis and the pandemic. In each of these major stress episodes, infrastructure investments dropped less than stocks, real estate, or private equity.

Drawdowns of infrastructure and other real assets

Source: Ravenhorst and Brounen (2022)

But if infrastructure investments are supported by declining discount rates, shouldn’t they suffer from rising discount rates as well? That’s the key problem with infrastructure investments. On the one hand, infrastructure contracts often have a direct or indirect link to inflation. Revenues from infrastructure projects are often linked to inflation, creating cash flows that regularly adjust upwards in times of rising inflation.

However, as inflation rises, so do discount rates and that means that infrastructure investments derate. If this discount rate effect dominates in times of low inflation it should also dominate in times of rising inflation. In other words, while cash flows of infrastructure projects rise with inflation, this increase is slower than the devaluation of the project due to rising discount rates. No wonder then that Georg Inderst found already more than a decade ago that infrastructure funds tend to have some ability to hedge against inflation, but investors in these funds aren’t necessarily able to capture this ability (mostly due to valuation effects). Wurstbauer and Schäfers (what a name…), meanwhile find that in the short run, only direct infrastructure investments provide an inflation hedge. In the long run, both listed and unlisted infrastructure does, which again can be reconciled with the impact of inflation and discount rates on valuation. Once inflation normalises, so do valuations and the end result is that the inflation hedge inherent in the cash flow of infrastructure projects is passed on to investors.

But as this study shows, the correlation between infrastructure returns and inflation tends to be higher than for equities but far from perfect, whether you look at normal inflation periods or periods of very high or very low inflation. Buying infrastructure investments as an inflation hedge only works if you have an extremely long investment horizon as pension funds do. For most investors, however, doing so is likely to result in disappointment.