Measuring Inflation Exposure and Managing Inflation Risk through Infrastructure Investments
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ab 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
2 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 3
4 Investment Note
Investment and inflation risk
Inflation is a major concern for all long-term investors Figure 2: CPI inflation in the OECD, US and UK, 1971-2011
and rightly so. Whether a private investor is looking to
30%
preserve and grow the purchasing power of her wealth
or an institutional investor with inflation linked liabilities is 25%
looking to match the exposure of its liabilities with its assets,
20%
protecting against the effects of inflation is critical
to successful investment outcomes. 15%
10%
Nevertheless, investors’ focus on inflation often depends
on recent history and their experience. Figure 1 shows 5%
a time series of estimated inflation for the UK over the 0%
past centuries. These data show that when the means of
-5%
exchange was based on a commodity with a real cost of 1971 1981 1991 2001 2011
production and limited supply, most commonly gold or silver, United Kingdom United States OECD
inflation was effectively a reflection of the changing relative
Source: OECD
prices of different goods. Accordingly, inflationary periods
and deflationary periods alternated in line with changes in While the great moderation might have suppressed investors’
relative supply and demand. Following the introduction of inflation risk aversion, the recent global economic and
paper money (fiat money) with effectively zero production financial crises have once again heightened inflation concerns
cost, inflationary and deflationary periods became less and investors are focusing on inflation risk with renewed
symmetric and more a product of government policy. vigor. Significantly, in recent years this concern has been as
Inflation offers governments, thanks to their monopoly over much about the potential for deflation especially in the short
the supply of currency, an easy and mostly hidden way to term as about accelerating inflation in the medium term.
tax the economy and to finance government expenditure.
In short, history shows that sustained high rates of inflation Two polar views are possible. On the one hand, the possibility
are a monetary phenomenon linked to the introduction and of the world economy going through a period of elevated
government control of fiat money. inflation is higher now than it has been for a long time.
With interest rates at historic lows for a prolonged period,
Figure 1: Annual inflation rate in the UK, 1250-2010 with the supply of money and central banks’ balance sheets
having expanded dramatically in recent years, and with
35%
higher inflation offering to ease the burden of much needed
30%
25% deleveraging, investors are wary of inflation for good reason.
20% On the other hand, economic weakness is still affecting
15% most of the developed economies. There are no signs that
10% monetary policy is fuelling credit growth or wage inflation
5% and a liquidity trap scenario where the increased money
0%
supply is absorbed by asset allocation adjustments remains
-5%
-10% a possibility, all of which point towards a low inflation or
-15% deflationary period. Japan’s experience over the past two
-20% decades offers parallels and is well within the range of
-25% possible outcomes.
-30%
1250 1400 1550 1700 1850 2000
Given the history of inflation and current uncertainties
Source: Lawrence H. Officer, Samuel H. Williamson, concerning future inflation, it is little wonder that inflation
MeasuringWorth.com
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.
Investment Note 5Protecting returns against inflation risk
Most long-term investors are focused on real returns rather Table 1: Real return vs inflation, 1900-2011
than nominal returns. To minimize their exposure to inflation, Asset Coefficient St Error t-statistic No of obs
the ideal investment would deliver a constant real return
Bills -0.62 0.01 -70.54 2123
irrespective of the inflation rate. Looking at historic returns
of various asset classes going back to 1900 (Table 1), we Bonds -0.74 0.02 -35.23 2123
can see that the real return of most asset classes drops with Equities -0.52 0.05 -10.60 2123
increasing inflation. The negative coefficient of the real return Gold 0.26 0.05 5.00 2123
on investments when regressed against the inflation rate Real estate -0.33 0.20 -1.60 280
measures the average size of this effect.
Housing -0.20 0.07 -2.99 719
Table 1 summarizes short term correlation of returns with Regressions of annual return versus same-year inflation
inflation. However, the impact of inflation on returns Source: A. Dimson, P Marsh, M. Staunton, J. Wilmot and P. McGinnie,
depends on the investment horizon and the correlation can Credit Suisse Global Investment Returns Yearbook 2012
differ significantly between the short and long-term. Table
2 summarizes the key inflation attributes of different asset There are instruments, notably inflation indexed bonds,
classes over different time horizons. It is worthwhile to note which offer direct inflation hedging. However, such
that the link between nominal returns and inflation, in terms investments are very scarce in comparison with the demand
of correlation, is generally stronger over the long-term as the from long-term investors. As a result, the real return that
effect of short term noise in the data diminishes. 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 Partial inflation hedge after rates catch up with inflation
(elasticity of up to 0.2) (elasticity up to 0.8)
Nominal bonds1 Nominal and real losses as yields rise No inflation hedge
(negative elasticity of up to 1.5) (slightly negative or around zero elasticity)
Inflation linked bonds Inflation hedge (elasticity of 1) Inflation hedge (elasticity of 1)
Equities1
Nominal and real losses as interest rates rise No inflation hedge as growth is affected by inflation
(negative elasticity of up to 0.8) (slightly negative elasticity)
Commodities1 Partial inflation hedge as prices respond to inflation shock No inflation hedge as growth is affected by inflation
(elasticity of up to 0.7) (slightly negative elasticity)
Infrastructure2 Inflation hedge subject to effective indexation Inflation hedge subject to effective indexation
(elasticity of around 1) (elasticity of around 1)
Property2 Inflation hedge if rent indexed; otherwise losses as yields Inflation hedge due to rent indexation or reset
rise (negative elasticity) (elasticity around 1 subject to cost structure)
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
6 Investment Notecountries is around zero and in some cases even negative. Infrastructure assets are commonly viewed as offering inflation
Investors are forced to find alternative investments to manage hedged returns and we agree that infrastructure investments can
their inflation risk. deliver inflation protection in the long-term. Nonetheless, as we
will argue in the remainder of this paper, this only holds under
Commodities have recently been the focus of a great deal certain conditions and investors need to carefully manage the
of investor attention including as an instrument for inflation inflation exposure of assets to achieve the desired protection.
hedging. Figure 3 shows commodity prices versus OECD
inflation. As discussed in respect of the long run inflation Figure 3: Consumer and commodity price inflation, 1981-2012, YoY
data in Figure 1, recent commodity price cycles exhibit
200%
much greater symmetry and are characterized by price
spikes and drops much more than recent general inflation. 150%
This emphasizes the importance of individual commodity
supply and demand balances for price movements. Further, 100%
it is interesting to note that the different commodity price 50%
indices (metals, agricultural and crude oil) often diverged
over the past three decades, so that during half of this 0%
period the inflation of one or two of these indices was
-50%
above consumer price inflation while the other one or two
were below it. -100%
1981 1986 1991 1996 2001 2006 2011
OECD CPI inflation Metals Price Index
Agricultural Raw Materials Index Crude Oil Index
Source: OECD, IMF
Investment Note 7Measuring the inflation exposure of infrastructure
Before we turn to the question of managing assets for real Elasticity and correlation measures
returns, we need to discuss the question of how to measure Elasticity measures the extent to which one variable
the inflation exposure of infrastructure investments. influences another. Specifically, it provides the ratio of
the percentage change in one variable to the percentage
Attributes focusing on the inflation indexation of revenues change in another. The basis point elasticity we use for
through either regulatory formulas or concession contracts managing inflation risk measures the ratio of the basis
are often cited as evidence or measures of inflation linked point (or percentage point) change in nominal returns to
returns. As discussed later in the paper, such a view is the basis point (or percentage point) change in inflation.
too simplistic given the range of other factors influencing The basis point elasticity is more meaningful and easier to
inflation exposure. Alternatively, the impact of different interpret for our purposes than a simple elasticity measure.
inflation scenarios on current valuation could be used For example, if inflation of 3 per cent results in nominal
to measure this exposure, and this might be appropriate returns of 10 per cent while inflation of 2 per cent would
for investments with a short holding period. Being long- correspond to a nominal return of 8 per cent, the basis
term investors and recognizing the illiquid nature of the point elasticity is 2 (200 basis divided by 100 basis point)
infrastructure asset class, our preferred measure is a return while a simple elasticity measure would be a less intuitive
sensitivity to changes in inflation. Specifically we use the basis 0.5 (25 per cent increase in return divided by 50 per cent
point elasticity of returns to inflation, which is calculated as increase in inflation).
the basis point change in nominal returns divided by the basis
point change in the inflation rate. Correlation, on the other hand, measures the consistency
but not the extent of the relationship between two
While it is a very useful tool, our measure and methodology variables. An 80 per cent correlation between long-term
has certain limitations that should be kept in mind. It assumes inflation and nominal returns would indicate that inflation
parallel shifts in inflation rates and at the portfolio level it explains a lot of the variation, i.e. the inflation is a major
assumes similar shifts across all countries represented in the driver of returns, but would not answer the question
portfolio. Further, it reflects the sensitivity to inflation at a whether a one percentage point higher inflation is likely to
specific point in time while the exposure might change over lead to a 2 percentage point increase in nominal returns,
time and needs to be managed on a continuous basis. Also, or to half a percentage point increase.
it measures elasticity to changes in one price index, most
commonly the consumer price index, while certain return Hence, elasticity measures are commonly used for risk
drivers could be more closely linked to different price indices, management purposes. The Greeks (for example delta,
for example the construction price index, resulting in some vega, theta) used in option theory and derivates based risk
basis risk. management are all elasticity measures.
8 Investment NoteDrivers of inflation sensitivity of infrastructure assets
The exposure of an infrastructure investment’s performance have different cost and financing structures. For reasons
to inflation is influenced by a range of factors. The revenue of simplicity we combine operating costs and capital
regime attracts most of the attention and full or partial expenditure under total expenditure (“totex”) and use an
indexation of revenues to inflation is quite common under operating margin that reflects both these costs.
both price and return regulation. However, the inflation
sensitivity of operating costs, capital expenditure as well as As can be seen from Table 3, asset A offers an equity return
the capital structure of the asset, among many other things, with a basis point elasticity of around 1.75 to inflation, while
have a huge influence on the sensitivity of equity returns. The asset B’s return elasticity is only 0.5. Notwithstanding the
illustrative, and admittedly not exact, calculations presented same revenue indexation, the fact that the majority of asset
in Table 3 provide an idea of the importance of these drivers. A’s costs are mostly fixed, while asset B’s costs are mostly
linked to inflation results in a very different inflation exposure
For our illustration we use the example of assets A and B and protection for the equity investor.
that have the same, partially indexed revenue regime but
Table 3
Asset A Indexation Asset B Indexation
Revenues 80% indexed Revenues 80% indexed
Totex 50% indexed Totex 100% indexed
Operating margin of 80% Operating margin of 80%
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 Approx 175% indexed2 Levered returns Approx 50% indexed2
1
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.
Investment Note 9Application of the elasticity measure to UBS IIF’s portfolio
While a rough calculation is useful to demonstrate the in the long-term. The effect of other factors on returns
contribution of different value drivers to inflation exposure, can easily dominate the influence of inflation in the short
it is both inaccurate and an oversimplification. Using a term, but the longer an investor’s time horizon, the more
detailed financial model to estimate the impact of different important the effect of inflation risk is.
inflation scenarios provides a more complete and accurate
picture and is more appropriate for the purposes of risk Finally, investors seeking protection against a local inflation
management. rate but investing globally or in international funds need to
consider the appropriateness of investments with returns
As part of our ongoing portfolio and asset management linked to inflation in other countries. Our view is that the
process, we track the inflation exposure of the investments suitability of a global strategy under such circumstances
of UBS International Infrastructure Fund. As of the last again depends on one’s investment horizon. As it has been
valuation date, September 2011, the basis point inflation confirmed by various studies1, the purchasing power parity
elasticity of the fund’s portfolio was approximately 1.2 theory of exchange rates holds over the long term meaning
meaning that a one percentage point increase in future that most of the variation in exchange rates over the
inflation rates would increase long-term nominal returns by long-term is explained by differences in the corresponding
around 1.2 percentage points. This elasticity is estimated inflation rates. The implication is that the combination of
assuming a sustained shift in inflation relative to the inflation linked assets in other currencies and no currency
underlying business plan across the holding period for the hedging provides fairly good protection against local
investment and shows that the fund is expected to provide inflation over the long-term. For example, a higher foreign
inflation protection in line with its mandate. inflation rate would lead to a higher nominal return in
the foreign currency than would be the case with a local
It should be emphasized that the above measure and investment, but this would be offset by a weakening foreign
application to inflation risk management is useful primarily currency over the long-term.
1
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
10 Investment NoteConclusion
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 long-
term 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
kate.martin@ubs.com
Arpad Cseh
Investment Executive
London
Tel. +44-207-901 59 94
Mobile +44-776-831 62 64
arpad.cseh@ubs.com
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