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I understand the information contained in this website is not directed at, nor is it intended for distribution to, or use by, persons in any jurisdiction in which the dissemination of such investment related information is not permitted. I also understand that the information contained in this site is not directed to any party that may be defined as a ‘retail investor’ by the home regulator of the country in which the website is being accessed. I understand that the information or opinions contained herein should not be construed as an offer to sell or the solicitation of an offer to buy any investment product nor shall any such investment products or services be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful. Fidelity has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

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Hiermit bestätige ich, dass ich diese Website zur Informationsbeschaffung als institutioneller Anleger (ein auf eigene Rechnung handelndes Unternehmen oder ein anderer nicht als Privatanleger geltender Investor) bzw. für einen institutionellen Anleger besuche.

Mir ist bewusst, dass sich die Informationen auf dieser Website nicht an Personen richten bzw. für sie bestimmt sind, in deren Land die Verbreitung solcher anlagebezogenen Informationen nicht erlaubt ist. Mir ist ebenfalls bewusst, dass sich die Informationen auf dieser Website nicht an Adressaten richtet, die von der Aufsichtsbehörde in dem Land, von dem aus die Website besucht wird, möglicherweise als „Privatanleger“ klassifiziert werden. Des Weiteren ist mir bewusst, dass die hier zu findenden Informationen oder Meinungen nicht als Aufforderung zum Kauf oder Verkauf eines Anlageprodukts zu verstehen sind. Es sollen auch keine solchen Anlageprodukte oder Dienstleistungen Personen angeboten oder verkauft werden, in deren Land ein entsprechendes Angebot, eine Aufforderung, ein Erwerb oder Verkauf ungesetzlich wäre. Fidelity äußert auf dieser Website seine eigenen Ansichten und Meinungen, die sich jederzeit ändern können, ohne dass eine Verpflichtung zur Aktualisierung besteht. Kein Inhalt dieser Website ist als Beratung in Bezug auf Geldanlagen, Steuern, rechtliche oder sonstige Aspekte zu verstehen. Die hierin enthaltenen Informationen können sich ohne entsprechende Mitteilung jederzeit ändern.

Diese Website wurde von FIL Fund Management Limited eingerichtet, einem Unternehmen mit Sitz auf bzw. nach dem Recht der Bermuda-Inseln, das über eine Genehmigung der Bermuda Monetary Authority zur Ausübung von Investmenttätigkeiten verfügt. Weder FIL Fund Management Limited noch sein Mutterunternehmen FIL Limited oder irgendein anderes Konzernunternehmen oder verbundenes Unternehmen übernimmt die Gewähr dafür oder erklärt, dass die Informationen auf dieser Website zutreffend, vollständig oder für jedwede Zwecke geeignet sind.

Ich erkenne an, dass weder FIL Fund Management Limited noch FIL Limited oder ein anderes Konzernunternehmen bzw. verbundenes Unternehmen für etwaige Verluste haftet, die direkt oder indirekt aus einer auf dieser Website beschafften Information resultieren. Durch Annahme dieser Erklärung bestätige ich auch mein Einverständnis mit den Nutzungs- und Geschäftsbedingungen dieser Website, die ich gelesen und verstanden habe.

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Contractualised income: Low risk, not no risk

by Adrian Benedict and George Watson

Published 4 July 2019

IncomeReal Estate

Real assets that collect an income stream from licences or rents enshrined in a contract have attracted pension funds, insurance groups and other long-term investors. Such investments fill a need for inflation-linked, predictable cashflows. However, while these assets appear to be low risk, a forward-looking assessment of the underlying business risk is the best way to determine pricing accurately.

Demographic changes are reshaping the investment landscape in many ways. Wealth is now increasingly concentrated in the hands of over-55s. These are investors who have toiled and saved through the accumulation phase. What they need now is an income stream in retirement that doesn’t risk the capital they’ve built up. 

Pension funds and insurance companies are taking steps to cover their liability profiles in the face of these new demographic realities. But to do that they need assets that generate income. Equities carry too much risk. Even defensive stocks are too sensitive to market vacillations for some needs. And thanks to the mass purchase of bonds by central banks in the last 10 years, fixed income, the former mainstay of pension funds, is only delivering the first half of its name. So institutional investors need an alternative. And that’s where contractualised income can step in.

This involves private market exposure to a real asset that comes with a contractual obligation to pay the owner a regular income for an extended period of time, often rising in line with inflation. Most importantly, the income streams have little correlation to the underlying business cycle. Exposure is often via private ownership but can also take the form of long-dated debt, trade finance receivables (a way of pledging future income to raise finance now) and project finance. At an asset level, contractual income can come from long-lease property, ground rent, utilities, airports, toll roads, railway rolling stock, mobile phone masts, social housing, schools, data centres, student accommodation, marinas, care homes, and renewable energy projects - among many others.

These assets suit long-term investors happy to assume the illiquidity risk in exchange for diversity and contractual certainty at a higher return than corporate bonds. https://www.bnymellon.com/us/en/_locale-assets/pdf/global-public-investors-and-the-real-assets-market.pdf found that infrastructure and real estate investments by sovereign and pension funds rose by 165 per cent and 120 per cent respectively between 2009-2017. The trend has been particularly pronounced in the UK, where recent government regulation has encouraged investment in real assets. Pension funds now fully or part-own London Tideway, a new ‘super sewer’ under construction under the city, the Eurostar rail company and numerous UK airports.

Weighing up the pros and cons

On one hand, contractualised income can be a sensible way to match the duration of liabilities. It offers access to cashflows from assets that are not in the public domain. The income streams are weakly correlated with each other and with the broader business climate, helping to diversify a portfolio. It also provides an excellent opportunity to finance environmentally and socially conscious projects. 

However, the recent rise in demand has caused prices to rise and yields to fall. While supply may not be fixed, it is certainly constrained, and many of the choicest assets have already been snapped up. Investors are now moving into more esoteric assets in search of yield. What appears to be a very safe asset class still has sources of risk.

Low risk, not no risk

Firstly, the investment horizon for secure-income assets is considerably longer than other asset classes, including traditional real estate. The 25-odd years that is a typical investment horizon for such assets is long enough for regulatory, technological and societal changes to render pockets of the economy unrecognisable. This type of risk is notoriously difficult to weigh accurately, made harder still by the illiquidity of the investments in question.

Secondly, the political climate is evolving. Governments are savvier these days, less willing to sell state assets at attractive prices and more willing to scrutinise state-guaranteed income on regulated assets. Populism is tilting the debate around public and private ownership. In the UK there is a reasonable chance that the Labour Party could ascend to power in the next few years on a manifesto that promises to renationalise water provision and railways in the UK.

Lastly, and perhaps most importantly, because this trend has only taken hold in the past 10 years, cashflows from these assets have not been tested throughout an entire economic cycle. The business models that support their income streams have not come under significant pressure in many industries since the financial crisis. They may be a contractual obligation, but that does not mean the creditor will be able to honour that contract. This is especially pertinent as investors are steered into more arcane assets.

Business risk is paramount

Analysing the business risk that underwrites cashflows is an important aspect of real asset investment. An example from our own experience is our purchase of three logistics warehouses in Germany between 2012-2015. In addition to a full analysis of the property, we were also able to use our proprietary research to assess the business risk of the tenant, DHL. Even as the dynamics of global trade have come under threat in the last few years, the income stream is backed by a diversified conglomerate which is 30 per cent owned by the German government, making a default on obligations unlikely.

We secured investment grade covenants on the 10-year leases agreed with the company at an average yield of 6.8 per cent, a healthy premium for illiquidity compared to the 3 per cent and 1.5 per cent that DHL’s equity and bonds were yielding at the time.

Another example, also from Germany, is the purchase of warehouses for Do It Yourself retailer Toom in 2016 and 2017. Much of the sector is facing stiff competition from internet retailers, but we felt Toom would be able to leverage its physical presence to become effective through this channel itself. The DIY sector is also a proxy for the German housing market which we expected to remain buoyant. And the problems affecting the broader retail sector allowed us to secure 15-year inflation-linked leases at an average yield of 6.6 per cent, a premium of between 1.5-2 per cent over a conventional food retailer.

The human trait of extrapolating the present into the imagined future is difficult to dislodge. Whatever comes after this cycle - be it downturn, transition period or renewed growth - will put some parts of the economy that may look very secure now under stress. Many contractualised income assets will weather the storm. But as real asset owners move into ever-more niche areas, a deep appraisal of the business on the hook for the cashflows and not just the underlying physical assets is paramount.

The growing ranks of elderly investors with lower risk appetites means that contractualised income will play a bigger role in portfolios in the future. But at the same time the speed of disruption is getting faster, making it more important to effectively assess credit risk in private markets. A contract reduces risk but cannot eliminate it altogether. It is our job as investors to make sure the risk we do choose to take is priced in our favour.

. Source: Refinitiv, Fidelity International, July 2019.

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These materials do not constitute a distribution, an offer or solicitation to engage the investment management services of Fidelity, or an offer to buy or sell or the solicitation of any offer to buy or sell any securities or investment product. Fidelity makes no representations that the contents are appropriate for use in all locations or that the transactions or services discussed are available or appropriate for sale or use in all jurisdictions or countries or by all investors or counterparties. 

Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. They are valid only as the of the date indicated and are subject to change without notice.

This material was created by Fidelity International. It must not be reproduced or circulated to any other party without prior permission of Fidelity.

This communication is not directed at and must not be acted on by persons inside the United States and is otherwise only directed at persons residing in jurisdictions where the relevant funds are authorised for distribution or where no such authorisation is required. Fidelity is not authorised to manage or distribute investment funds or products in, or to provide investment management or advisory services to persons resident in, mainland China. All persons and entities accessing the information do so on their own initiative and are responsible for compliance with applicable local laws and regulations and should consult their professional advisers. 

This content may contain materials from third-parties which are supplied by companies that are not affiliated with any Fidelity entity (Third-Party Content). Fidelity has not been involved in the preparation, adoption or editing of such third-party materials and does not explicitly or implicitly endorse or approve such content. Fidelity International refers to the group of companies which form the global investment management organisation that provides products and services in designated jurisdictions outside of North America Fidelity, Fidelity International, the Fidelity International logo and F symbol are trademarks of FIL Limited. Fidelity only offers information on products and services and does not provide investment advice personal recommendations based on individual circumstances. 

Issued in Europe: Issued by FIL Investments International (FCA registered number 122170) a firm authorised and regulated by the Financial Conduct Authority, FIL (Luxembourg) S.A., authorised and supervised by the CSSF (Commission de Surveillance du Secteur Financier) and FIL Investment Switzerland AG, authorised and supervised by the Swiss Financial Market Supervisory Authority FINMA. For German wholesale clients issued by FIL Investment Services GmbH, Kastanienhöhe 1, 61476 Kronberg im Taunus. For German institutional clients issued by FIL Investments International – Niederlassung Frankfurt. 

In Hong Kong, this content is issued by FIL Investment Management (Hong Kong) Limited and it has not been reviewed by the Securities and Future Commission. FIL Investment Management (Singapore) Limited (Co. Reg. No: 199006300E) is the legal representative of Fidelity International in Singapore. FIL Asset Management (Korea) Limited is the legal representative of Fidelity International in Korea. In Taiwan, independently operated by FIL Securities (Taiwan ) Limited, 11F, 68 Zhongxiao East Road, Section 5, Xinyi Dist., Taipei City, Taiwan 11065, R.O.C. Customer Service Number: 0800-00-9911#2. 

Issued in Australia by Fidelity Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”). This material has not been prepared specifically for Australian investors and may contain information which is not prepared in accordance with Australian law. 

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