June 20, 2017
- The Trump administration has indicated infrastructure spending is a top priority
- Investment opportunities already exist for municipal bonds and stock funded infrastructure projects
- These investments have the potential to diversify portfolios and may offer lower risk as compared to other asset classes
Summer travel will expose millions of Americans to the state of the nation’s infrastructure, including roads, airports, and bridges. Decades of neglect have created a massive backlog of projects to rebuild communities, modernize energy and water systems, and in some cases, prevent collapse.
With total costs estimated in the trillions of dollars, major infrastructure spending could stimulate the economy, create jobs, and provide new opportunities for investors. The Trump administration has proposed spending $1 trillion over 10 years — so far without details on how to pay for it. With proposals calling for large tax cuts now on the table, Congress may not agree to significant spending increases as well. It is too soon to predict the impact of any new federal infrastructure initiatives.
Investing in infrastructure
Fortunately, the infrastructure investment opportunity does not depend on Washington. State and local governments already fund most existing infrastructure projects, and private industry is investing heavily in energy and telecommunications infrastructure to stay competitive.
Infrastructure is a separate asset class with risk and return characteristics distinct from traditional stocks and bonds. Generally speaking, infrastructure investments have relatively stable cash flows — backed by government or contractual guarantees — related to essential services with steady demand. Stable income can mean less sensitivity to economic cycles with historically lower volatility and higher risk-adjusted returns, compared to broader markets. An additional potential benefit is that infrastructure investments provide portfolio diversification because they tend to perform differently from other asset classes. It is important to note that any investment concentrated in infrastructure-related securities involves sector and concentration risks, particularly greater exposure to adverse economic, regulatory, political, legal, liquidity, and tax risks associated with Master Limited Partnerships (MLPs) and REITs.
Municipal bonds are a core infrastructure investment
Municipal bonds fund most of the public infrastructure in the U.S. This is a massive $3.8 trillion market, with more than $400 billion in bonds issued annually to finance more than 10,000 projects. Investors often buy municipal bonds primarily because they provide income that is generally exempt from income tax. However, municipal bonds may also offer lower volatility and diversification benefits.
Municipal bonds historically have offered several advantages over similarly-rated corporate bonds:
- Equivalent or better after-tax yields
- Lower volatility
- Lower default risk
As a result, municipals have historically generated attractive risk-adjusted returns, compared to most major asset classes. The Sharpe Ratio, which is used to measure risk-adjusted returns, indicates average excess returns an asset class has earned historically compared to a “risk-free” rate represented by a 3-month U.S. Treasury note. The higher the Sharpe ratio the better the historical risk-adjusted performance. This ratio is calculated by using standard deviation and excess return to determine reward per unit of risk. However, bear in mind that past performance is not an indicator of future results. It is also important to note that municipal securities are subject to other risks related to the market, credit, income and interest rates. In general, as interest rates rise, bond prices fall.
Infrastructure stocks offer unique potential
Infrastructure stocks cover a broad range of assets, including privatized airports, toll roads, alternative energy (i.e., wind and solar), oil and gas pipelines, cell phone towers and data centers. One of the primary investment benefits is diversification — less than 3% of this stock category overlaps with global equity indexes, according to Factset.
As location-specific assets with stable income returns driven by contractual payments, infrastructure stocks historically offered attractive risk-adjusted returns compared to equities. Because they are less correlated to the broader international market, they have tended to capture a bigger share of the market’s gains than its losses.
With their distinct risk and return profiles, municipal bonds and U.S. infrastructure stocks may offer the potential to improve risk-adjusted returns when added to traditional stock-bond portfolios. Investors may want to consider investments offering broadly diversified exposure to municipal bonds, or customized investments specializing in infrastructure stocks as they can help manage risk by offering broad diversification.
Investors can take advantage of infrastructure investment opportunities without waiting for Congress to act. Municipal bonds and infrastructure stocks offer an effective way to diversify risk in traditional stock and bond portfolios. Your financial advisor can help you determine if U.S. infrastructure investments may make sense in your broader portfolio mix.