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Infrastructure and Private Equity Asset Management

For Professional / Qualified Institutional Investors only – August 2012

Measuring Inflation Exposure and Managing Inflation Risk through Infrastructure Investments

“Inflation is a periodically recurring evidence of the fact that printed money is printed money” Helmar Nahr, German economist and mathematician

Investment Note Infrastructure and Private Equity Unless otherwise indicated, source is UBS Global Asset Management

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Investment Note

Executive summary Historically, inflation has been a major concern for long-term investors. The uncertain economic and inflation outlooks we face at present appear to have heightened investor appetite for investments that provide inflation linked returns. However, there is considerable debate about the inflation protection attributes of the various asset classes. This investment note contributes to this debate with a focus on infrastructure. Infrastructure investments can offer attractive risk adjusted real returns and protection against inflation. Investors need to be careful though to avoid generalizations for the asset class and to consider the characteristics of each individual asset. As we show in this paper, assets that appear superficially to have similar inflation sensitivities can deliver very different exposures to investors. To support the discussion we introduce our preferred metric, the inflation elasticity of total returns, to measure the inflation exposure of infrastructure investments. Using UBS International Infrastructure Fund as an example, we demonstrate our approach to managing inflation risk and providing inflation linked returns to investors. Finally, we argue that for investors with a long-term investment horizon a global investment strategy can deliver protection against local inflation.

Investment Note

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Investment and inflation risk Inflation is a major concern for all long-term investors and rightly so. Whether a private investor is looking to preserve and grow the purchasing power of her wealth or an institutional investor with inflation linked liabilities is looking to match the exposure of its liabilities with its assets, protecting against the effects of inflation is critical to successful investment outcomes. Nevertheless, investors’ focus on inflation often depends on recent history and their experience. Figure 1 shows a time series of estimated inflation for the UK over the past centuries. These data show that when the means of exchange was based on a commodity with a real cost of production and limited supply, most commonly gold or silver, inflation was effectively a reflection of the changing relative prices of different goods. Accordingly, inflationary periods and deflationary periods alternated in line with changes in relative supply and demand. Following the introduction of paper money (fiat money) with effectively zero production cost, inflationary and deflationary periods became less symmetric and more a product of government policy. Inflation offers governments, thanks to their monopoly over the supply of currency, an easy and mostly hidden way to tax the economy and to finance government expenditure. In short, history shows that sustained high rates of inflation are a monetary phenomenon linked to the introduction and government control of fiat money. Figure 1: Annual inflation rate in the UK, 1250-2010 35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% 1250

1400

1550

1700

1850

2000

Source: Lawrence H. Officer, Samuel H. Williamson, MeasuringWorth.com

Figure 2: CPI inflation in the OECD, US and UK, 1971-2011 30% 25% 20% 15% 10% 5% 0% -5% 1971

1981 United Kingdom

1991

2001

United States

OECD

2011

Source: OECD

While the great moderation might have suppressed investors’ inflation risk aversion, the recent global economic and financial crises have once again heightened inflation concerns and investors are focusing on inflation risk with renewed vigor. Significantly, in recent years this concern has been as much about the potential for deflation especially in the short term as about accelerating inflation in the medium term. Two polar views are possible. On the one hand, the possibility of the world economy going through a period of elevated inflation is higher now than it has been for a long time. With interest rates at historic lows for a prolonged period, with the supply of money and central banks’ balance sheets having expanded dramatically in recent years, and with higher inflation offering to ease the burden of much needed deleveraging, investors are wary of inflation for good reason. On the other hand, economic weakness is still affecting most of the developed economies. There are no signs that monetary policy is fuelling credit growth or wage inflation and a liquidity trap scenario where the increased money supply is absorbed by asset allocation adjustments remains a possibility, all of which point towards a low inflation or deflationary period. Japan’s experience over the past two decades offers parallels and is well within the range of possible outcomes. Given the history of inflation and current uncertainties concerning future inflation, it is little wonder that inflation risk is a prominent topic for long-term investors.

Figure 2 focuses on more recent inflation history in the OECD, the US and the UK. The data highlights what has become known as the “great moderation”, which has seen declining and then relatively stable low levels of inflation in the three decades following the high and volatile inflation of the 1970s and early 1980s. Independent central banks with credible inflation targets together with improving fiscal balances contributed to bringing inflation under control.

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Protecting returns against inflation risk Most long-term investors are focused on real returns rather than nominal returns. To minimize their exposure to inflation, the ideal investment would deliver a constant real return irrespective of the inflation rate. Looking at historic returns of various asset classes going back to 1900 (Table 1), we can see that the real return of most asset classes drops with increasing inflation. The negative coefficient of the real return on investments when regressed against the inflation rate measures the average size of this effect. Table 1 summarizes short term correlation of returns with inflation. However, the impact of inflation on returns depends on the investment horizon and the correlation can differ significantly between the short and long-term. Table 2 summarizes the key inflation attributes of different asset classes over different time horizons. It is worthwhile to note that the link between nominal returns and inflation, in terms of correlation, is generally stronger over the long-term as the effect of short term noise in the data diminishes.

Table 1: Real return vs inflation, 1900-2011 Coefficient

St Error

t-statistic

No of obs

Bills

Asset

-0.62

0.01

-70.54

2123

Bonds

-0.74

0.02

-35.23

2123

Equities

-0.52

0.05

-10.60

2123

Gold

0.26

0.05

5.00

2123

Real estate

-0.33

0.20

-1.60

280

Housing

-0.20

0.07

-2.99

719

Regressions of annual return versus same-year inflation Source: A. Dimson, P Marsh, M. Staunton, J. Wilmot and P. McGinnie, Credit Suisse Global Investment Returns Yearbook 2012

There are instruments, notably inflation indexed bonds, which offer direct inflation hedging. However, such investments are very scarce in comparison with the demand from long-term investors. As a result, the real return that such instruments currently trade at in many developed

Table 2: Inflation sensitivity of returns in the short and long-term ( elasticity of nominal returns in brackets) Asset

Short-term (1-3 years)

Long-term (5-20 years)

Cash1

Real losses as interest rates rise gradually (elasticity of up to 0.2)

Partial inflation hedge after rates catch up with inflation (elasticity up to 0.8)

Nominal bonds1

Nominal and real losses as yields rise (negative elasticity of up to 1.5)

No inflation hedge (slightly negative or around zero elasticity)

Inflation linked bonds

Inflation hedge (elasticity of 1)

Inflation hedge (elasticity of 1)

Equities

Nominal and real losses as interest rates rise (negative elasticity of up to 0.8)

No inflation hedge as growth is affected by inflation (slightly negative elasticity)

Commodities1

Partial inflation hedge as prices respond to inflation shock (elasticity of up to 0.7)

No inflation hedge as growth is affected by inflation (slightly negative elasticity)

Infrastructure2

Inflation hedge subject to effective indexation (elasticity of around 1)

Inflation hedge subject to effective indexation (elasticity of around 1)

Property2

Inflation hedge if rent indexed; otherwise losses as yields rise (negative elasticity)

Inflation hedge due to rent indexation or reset (elasticity around 1 subject to cost structure)

1

Source: 1 A.P. Attié and S.L. Roache, Inflation Hedging for Long-Term Investors, IMF Working Paper 09/90; 2 UBS Global Asset Management

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countries is around zero and in some cases even negative. Investors are forced to find alternative investments to manage their inflation risk. Commodities have recently been the focus of a great deal of investor attention including as an instrument for inflation hedging. Figure 3 shows commodity prices versus OECD inflation. As discussed in respect of the long run inflation data in Figure 1, recent commodity price cycles exhibit much greater symmetry and are characterized by price spikes and drops much more than recent general inflation. This emphasizes the importance of individual commodity supply and demand balances for price movements. Further, it is interesting to note that the different commodity price indices (metals, agricultural and crude oil) often diverged over the past three decades, so that during half of this period the inflation of one or two of these indices was above consumer price inflation while the other one or two were below it.

Infrastructure assets are commonly viewed as offering inflation hedged returns and we agree that infrastructure investments can deliver inflation protection in the long-term. Nonetheless, as we will argue in the remainder of this paper, this only holds under certain conditions and investors need to carefully manage the inflation exposure of assets to achieve the desired protection. Figure 3: Consumer and commodity price inflation, 1981-2012, YoY 200% 150% 100% 50% 0% -50% -100% 1981 1986 1991 1996 2001 2006 OECD CPI inflation Metals Price Index Agricultural Raw Materials Index Crude Oil Index

2011

Source: OECD, IMF

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Measuring the inflation exposure of infrastructure Before we turn to the question of managing assets for real returns, we need to discuss the question of how to measure the inflation exposure of infrastructure investments. Attributes focusing on the inflation indexation of revenues through either regulatory formulas or concession contracts are often cited as evidence or measures of inflation linked returns. As discussed later in the paper, such a view is too simplistic given the range of other factors influencing inflation exposure. Alternatively, the impact of different inflation scenarios on current valuation could be used to measure this exposure, and this might be appropriate for investments with a short holding period. Being longterm investors and recognizing the illiquid nature of the infrastructure asset class, our preferred measure is a return sensitivity to changes in inflation. Specifically we use the basis point elasticity of returns to inflation, which is calculated as the basis point change in nominal returns divided by the basis point change in the inflation rate. While it is a very useful tool, our measure and methodology has certain limitations that should be kept in mind. It assumes parallel shifts in inflation rates and at the portfolio level it assumes similar shifts across all countries represented in the portfolio. Further, it reflects the sensitivity to inflation at a specific point in time while the exposure might change over time and needs to be managed on a continuous basis. Also, it measures elasticity to changes in one price index, most commonly the consumer price index, while certain return drivers could be more closely linked to different price indices, for example the construction price index, resulting in some basis risk.

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Elasticity and correlation measures Elasticity measures the extent to which one variable influences another. Specifically, it provides the ratio of the percentage change in one variable to the percentage change in another. The basis point elasticity we use for managing inflation risk measures the ratio of the basis point (or percentage point) change in nominal returns to the basis point (or percentage point) change in inflation. The basis point elasticity is more meaningful and easier to interpret for our purposes than a simple elasticity measure. For example, if inflation of 3 per cent results in nominal returns of 10 per cent while inflation of 2 per cent would correspond to a nominal return of 8 per cent, the basis point elasticity is 2 (200 basis divided by 100 basis point) while a simple elasticity measure would be a less intuitive 0.5 (25 per cent increase in return divided by 50 per cent increase in inflation). Correlation, on the other hand, measures the consistency but not the extent of the relationship between two variables. An 80 per cent correlation between long-term inflation and nominal returns would indicate that inflation explains a lot of the variation, i.e. the inflation is a major driver of returns, but would not answer the question whether a one percentage point higher inflation is likely to lead to a 2 percentage point increase in nominal returns, or to half a percentage point increase. Hence, elasticity measures are commonly used for risk management purposes. The Greeks (for example delta, vega, theta) used in option theory and derivates based risk management are all elasticity measures.

Drivers of inflation sensitivity of infrastructure assets The exposure of an infrastructure investment’s performance to inflation is influenced by a range of factors. The revenue regime attracts most of the attention and full or partial indexation of revenues to inflation is quite common under both price and return regulation. However, the inflation sensitivity of operating costs, capital expenditure as well as the capital structure of the asset, among many other things, have a huge influence on the sensitivity of equity returns. The illustrative, and admittedly not exact, calculations presented in Table 3 provide an idea of the importance of these drivers. For our illustration we use the example of assets A and B that have the same, partially indexed revenue regime but

have different cost and financing structures. For reasons of simplicity we combine operating costs and capital expenditure under total expenditure (“totex”) and use an operating margin that reflects both these costs. As can be seen from Table 3, asset A offers an equity return with a basis point elasticity of around 1.75 to inflation, while asset B’s return elasticity is only 0.5. Notwithstanding the same revenue indexation, the fact that the majority of asset A’s costs are mostly fixed, while asset B’s costs are mostly linked to inflation results in a very different inflation exposure and protection for the equity investor.

Table 3 Asset A

Indexation

Asset B

Indexation

Revenues Totex Operating margin of 80%

80% indexed 50% indexed

Revenues Totex Operating margin of 80%

80% indexed 100% indexed

Unlevered returns

Approx 87.5% indexed1

Unlevered returns

Approx 75% indexed1

Fixed rate debt

0%

Indexed debt

100%

Debt service of 50 % as a portion of unlevered cash flows

Debt service of 50 % as a portion of unlevered cash flows

Levered returns

Levered returns

Approx 175% indexed2

Approx 50% indexed2

Calculated as (Revenue indexation - (1 - Operating) x Totex indexation)/Operating margin. (80%-0.2*50%)/80% for A and (80%0.2*100%)/80% for B. 2 Calculated as (Unlevered return - Debt service ratio x Debt indexation) / (1 - Debt service ratio). (87.5%-50%*0%)/(1-50%) for A and (75%-50%*100%)/(1-50%) for B. Note that the above calculation is only an approximation based on simplified assumptions and ignoring non linear nature of growth rates such as inflation or nominal return. 1

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Application of the elasticity measure to UBS IIF’s portfolio While a rough calculation is useful to demonstrate the contribution of different value drivers to inflation exposure, it is both inaccurate and an oversimplification. Using a detailed financial model to estimate the impact of different inflation scenarios provides a more complete and accurate picture and is more appropriate for the purposes of risk management. As part of our ongoing portfolio and asset management process, we track the inflation exposure of the investments of UBS International Infrastructure Fund. As of the last valuation date, September 2011, the basis point inflation elasticity of the fund’s portfolio was approximately 1.2 meaning that a one percentage point increase in future inflation rates would increase long-term nominal returns by around 1.2 percentage points. This elasticity is estimated assuming a sustained shift in inflation relative to the underlying business plan across the holding period for the investment and shows that the fund is expected to provide inflation protection in line with its mandate. It should be emphasized that the above measure and application to inflation risk management is useful primarily

For example The Purchasing Power Parity Debate by Alan M. Taylor and Mark P. Taylor, Journal of Economic Perspectives—Volume 18, Number 4—Fall 2004—Pages 135–158

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in the long-term. The effect of other factors on returns can easily dominate the influence of inflation in the short term, but the longer an investor’s time horizon, the more important the effect of inflation risk is. Finally, investors seeking protection against a local inflation rate but investing globally or in international funds need to consider the appropriateness of investments with returns linked to inflation in other countries. Our view is that the suitability of a global strategy under such circumstances again depends on one’s investment horizon. As it has been confirmed by various studies1, the purchasing power parity theory of exchange rates holds over the long term meaning that most of the variation in exchange rates over the long-term is explained by differences in the corresponding inflation rates. The implication is that the combination of inflation linked assets in other currencies and no currency hedging provides fairly good protection against local inflation over the long-term. For example, a higher foreign inflation rate would lead to a higher nominal return in the foreign currency than would be the case with a local investment, but this would be offset by a weakening foreign currency over the long-term.

Conclusion Having examined the inflation attributes of the infrastructure asset class, we conclude that infrastructure investments can offer inflation linked returns and can be a valuable tool for the inflation risk management of a portfolio. However, this conclusion only holds under certain conditions and requires careful management both at the asset and portfolio level. Focusing on the inflation link of revenues is not sufficient and can mask important aspects relevant for managing inflation risk. A strategy targeting inflation protection requires a comprehensive view of the inflation attributes of all return drivers, including operating costs, capital expenditure and the capital structure. Further, pursuing inflation protection is more relevant and realistic over the long-term, as other factors tend to dominate the effect of inflation on returns in the short term. The longterm nature of infrastructure lends itself to long-term investment and accordingly to inflation risk management.

Contacts Kate Martin Investor Relations Executive New York Tel. +1-212-821 65 57 Mobile +1-347-439 83 36 [email protected] Arpad Cseh Investment Executive London Tel. +44-207-901 59 94 Mobile +44-776-831 62 64 [email protected]

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