Five ways to invest in infrastructure

It's more than years since HSBC Infrastructure floated on the London stockmarket. Its objective was to provide investors with a high level of income, growing at least in line with inflation, through equity investment in private finance initiative (PFI) projects sourced or developed internally. The company, now called HICL Infrastructure (LSE: HICL) following its split from HSBC, has certainly delivered, with an annualised return of 10% since launch.

Babcock & Brown Infrastructure, now called International Public Partnerships (LSE: INPP), followed a few months later and 3i Infrastructure (LSE: 3IN), a spin out from 3i, listed a year later. John Laing Infrastructure (LSE: JLIF), which floated in 2010, and Bilfinger Berger Global Infrastructure (LSE: BBGI) in 2011 complete the quintet of major UK-listed infrastructure funds, although they are supplemented by a number of firms in sectors such as alternative energy and the long-term rental of health centres.

The annualised returns of the five funds fall within a fairly narrow range, but the business models are slightly different. HICL remains a relatively pure play on operational PFI in the UK (83% of assets), while BBGI has over 60% of its assets in Europe, Australia and North America.

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3IN invests primarily in utilities, rather than PFI projects, with stakes in Anglian Water and Cross London Trains, which leases rolling stock to Thameslink. JLIF and INPP are also diversifying into utilities, with the former buying into Barcelona's metro system and the latter buying into National Grid's gas distribution network. These investments are higher risk than PFI, but also higher reward. As competition erodes the returns on new PFI projects, this trade-off has become attractive.

However, PFI is still at the heart of the sector. Since the early 1990s, contracts have been handed to the private sector to build, own and operate schools, hospitals, roads, bridges and other assets on behalf of the public sector. The infrastructure funds only become involved when the higher-risk construction phase is complete, but the operational phase, typically 25-30 years before it reverts to the government, is still not risk-free.

To raise the return on the equity it owns, the infrastructure company injects a substantial amount of long-term debt. It must ensure that the contracted payments not only cover loan interest, maintenance and operational costs, but provide a return to investors as well. The careful matching of guaranteed income, usually inflation linked, to expenses requires the sort of finance director who enjoys watching paint dry.

Many investors are put off by the premiums to net asset value at which the funds trade, but that is a mistake. Asset values are derived from discounting future cash flows. It suits management to set the discount rate high not only to be conservative, but also to ensure that new shares can be issued for acquisitions without apparent dilution. The rise in bond yields in late 2016 brought these premiums down to more reasonable levels of below 10%, and such an opportunity should recur before long.

Yields range from 4% for 3IN to 5.3% for JLIF, but dividends should rise at least in line with inflation. Future returns from infrastructure funds are unlikely to be as good as from equities, but offer a compelling alternative to government or corporate bonds. HICL is, rightly, regarded as the blue chip of the sector, but BBGI benefits from geographical diversification, 3IN has 3i keeping an eagle eye on it, JLIF looks the cheapest and INPP is probably the most improved.