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Rising Interest Rates Loom Over Energy and Infrastructure

Ed Sappin headshotWords by Ed Sappin
Investment & Markets
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The Federal Reserve continued to raise interest rates in 2018 as we reached the end of one of the longest bull markets in United States history. As the market cycle turns and the likely economic correction plays out in the coming months and years, what are the implications for the energy and infrastructure markets, which have greatly benefited from low interest rates?

Interest rates have been historically low since the 2008 financial crisis to encourage borrowing and to boost economic activity. The Federal Reserve has been increasing interest rates since 2015, raising their target Fed Funds benchmark four times in 2018 to 2.5 percent. While they are likely to slow the increases, with the Atlanta Fed just opining that only one rate increase in 2019 will likely be needed, the Fed clearly believes today’s economy is strong enough that the stimulus provided by low interest rates is no longer necessary and inflation is the larger long-term threat to the economy.

Higher interest rates increase bank profits, but they make borrowing more expensive, and normally mitigate price inflation. Despite interest rates reflecting an increased confidence in the economy, analysts worry that increasing rates too quickly could lead to another recession.

When the Fed changes interest rates, the effects ripple through the whole economy, affecting equity prices, bond interest rates, consumer and business spending, and inflation. For consumers, this means increases for credit card rates, student loans, and home mortgages. The Federal Reserve sets short-term interest rates, which typically carry over to long-term rates. Investors are already beginning to see changes, with energy and infrastructure markets one of the sectors being affected.

Energy and infrastructure markets have relied on low interest rates over the past decade to grow substantially, leaning on lower costs and debt financing to create above market returns primarily for pension funds, endowments, and other institutional investors. A typical energy or infrastructure project uses 60-75 percent debt financing, so higher interest rates mean that a project will have lower equity returns since debt becomes more costly (If more money goes to pay off debt to banks, then there is less equity return for investors). At the margins, projects will likely no longer be financeable as the economics cannot support the required returns to interest investors.

Project developers, who take the initial risk in creating and developing a project prior to construction, face the greatest uncertainty. Rising interest rates may be tough to overcome, and tariffs on raw materials and solar panels, for example, create a tangible increase in costs. Tariffs can raise cost per watt by 10 percent, while interest rate increases can result in even greater project cost increases. The higher the leverage in a project the more pronounced these increases can be, which ironically can mean that the best projects which banks are most willing to lend into are hurt the most. Whatever the case, while the solar markets continue to boom, developers are faced with either lower fees and profitability for their efforts, or at the worst case the less efficient shops will shut their doors as higher loan interest rates, higher origination fees, and tighter underwriting criteria put marginal projects under water.

Energy and infrastructure master limited partnerships (MLPs) have also been very popular over the last several years, as they provide relatively low risk, high yield investment opportunities. Rising interest rates mean that yields on other investments, such as money-market funds and treasury bonds, will also rise. This means that the energy and infrastructure-based MLPs will have more competition in attracting new capital. Moreover, MLPs suffered a setback last year due to a tax change on interest treatment.  Overall, higher interest rates are likely to mean the MLPs are in for a weaker performance in the next few years.

Much like solar and wind companies, data center and IT infrastructure REITs also typically utilize substantial leverage, leaving them vulnerable to raised interest rates. For example, according to a 2016 financial review that analyzed the debt structure of the three largest data center REITs, debt-to-equity ratios for the data center REITs range from 1.36 at the lowest, which is quite sustainable, to 2.75 at the highest, which is quite leveraged. To the extent interest rates are variable, which is a common feature, some of these investments begin to get much more risky with higher interest rates. In addition, many data center REITs will need to refinance a good portion of their debt in 2019, so higher interest rates will likely impact them negatively.

All is not lost, however. Solar, wind and storage markets continue to boom, with many banks belatedly recognizing that these investments are generally low risk. As confidence in solar increases, it will help mitigate some of the impacts of tariffs and higher Fed Funds rates. For example, spreads for solar projects have shrunk to as little as 100-150 basis points (1-1.5%) above LIBOR (the US interest rate as quoted in London, which is a typical measure) as opposed to the typical 200 or more basis points in the past. Foreign investors in particular are still eager to invest in U.S. assets, as they are seen as a safe haven for the coming market correction.

Given that there are a record $3+ trillion in assets under management in private equity and more specifically $173 billion in dry powder available in infrastructure funds, many energy and infrastructure projects continue to see high valuations as IRRs are forced downward. (The more you pay for a project, the lower the expected return.)  However, savvy investors understand that valuations are not necessarily reflections of growth or success, but of market supply and demand. It can become harder to distinguish which investments are truly worthwhile and can survive a market correction. With the economy at or near its peak, concerns are rising that the next six to 18 months will see the market faltering, or even dropping into a recession.

It is clear that for energy and infrastructure markets, rising interest rates spell a challenging road ahead. Savvier developers, equity investors, and debt providers are already anticipating the change and tightening their investment criteria while building in additional downside protections. Some are going even further and amassing capital for the next round of distressed assets to come.

For now, while energy and infrastructure remain strong markets, short and medium-term investors are increasingly understanding they are likely to have a higher level of risk than they have for the past number of years due to the repercussions of the Fed’s increase in interest rates. As long as investors keep a clear head and understand how higher rates can impact the projects and investments at which they are looking, they should be better placed to avoid the challenges and problems that the newly emerging market environment present.

Image credit: IPP/Flickr

Ed Sappin headshotEd Sappin

Ed Sappin is the founder and CEO of SGS (Sappin Global Strategies), an investment and advisory group building the next generation of global innovators. SGS focuses on its core verticals of technology and energy, as well as emerging areas including AI, blockchain, digital healthcare, and big data.

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