The role of core transportation in institutional portfolios
By Anurag Agarwal, Head of Portfolio Management, Global Transportation Group
Kris Kesting, Investment Specialist, Global Transportation Group
Transportation assets are the backbone of global trade and the complex supply chain. Whether they are moving consumer goods, commodities or passengers around the world, these assets are a critical component of global consumption and growth.
Long-term investors have always faced the challenge of reaching high return targets while maintaining appropriately diversified and liquid asset allocations. Today—with an increasingly uncertain equity market, growing concerns about rising inflation, and interest rates at or near all-time lows across the developed world—a traditional, liquid, market-focused 60/40 portfolio may no longer be able to meet the needs of return-focused investors. Fortunately, the expansion and diversification of alternative asset allocations, particularly in areas outside the more common private equity, real estate and hedge fund sectors, offer the prospect of improved investment performance.
One area of particular interest: core real assets, which are broadly understood to be high quality, long-lived physical assets that can provide stable cash flows under long-term contracts. They combine the income generation of a secure, fixed income-like return stream with the higher returns that come from owning specialized assets in industries with significant barriers to entry. In the hands of a skilled manager, core real assets deliver high levels of income and absolute return with low correlation to equity markets and protection against inflation. For pension funds and other investors with a need for regular liquidity to meet benefit payments or similar ongoing obligations, these assets’ combination of stable cash flows and returns that are broadly in line with strategic targets can be compelling.
Two of the three main components of core real assets are already well known: core real estate and core infrastructure. This article explores the third key component: core transportation.
Transportation: The engine of global trade
Transportation assets are the backbone of global trade and the complex supply chain. Whether they are moving consumer goods, commodities or passengers around the world, these assets are a critical component of global consumption and growth. As the world’s economy transitions to a more sustainable model of energy efficiency and sustainability, the transportation sector will play an ever more important role.
The vast size and economic significance of the transportation sector were highlighted in March 2021 when the Ever Given ultra large container ship ran aground in the Suez Canal, disrupting trade flows and supply chains at a cost of USD 9.6 billion a day. The accident also showed the increasing need for larger assets to meet growing consumer demand. As investors, however, we should appreciate how rare this type of disruption is in a global industry encompassing thousands of ships, ports and canals, and recognize the opportunity that arises from owning a stake in this vast enterprise. Long-term investments like these are well suited to long-term investors with limited short-term liquidity needs and liability obligations that extend decades into the future.
Core real assets offer alpha, income and diversification
For investors seeking to reach return targets and add diversifying asset classes, core real assets can serve as a dependable source of return and yield (Exhibit 1). The long-term outlook for real assets is attractive on a risk-adjusted return basis compared with most traditional assets. For total return-focused investors seeking diversification, a strong case can be made for using the asset class as a substitute for private credit and, in some cases, traditional fixed income allocations. For investors looking to de-risk, these assets can serve as a substitute for equities. According to our 2021 Long-Term Capital Market Assumptions (LTCMAs), core transportation offers a projected long-term return of 7.6%, with more than 90% of the total return delivered in the form of net cash yield.
EXHIBIT 1: CORE REAL ASSETS PORTFOLIO CONSTRUCTION
Core transportation investments offer stable cash flows, low volatility and the inflation protection of real assets
- Core real assets such as transportation, real estate and infrastructure derive stable income streams from long-term contractual cash flows and can offer investors alpha, income and diversification.
- Real assets boost diversification by offering exposure to uncorrelated economic factors.
- The assets’ attractive total return potential is supported by inflation protection, low correlation to financial assets and a yield premium.
Core transportation delivers stable income, low equity beta and a diversified source of returns
Transportation asset leasing is attracting significant investor attention because of its yield profile and its complementary role to real estate and infrastructure in a diversified portfolio. Core transportation assets—sometimes referred to as “moving infrastructure”—are some of the most prevalent means of connecting industries and economies. Assets including ships, aircraft, wind farm installation and service vessels, railcars and vehicles (Exhibit 2) are supported by long-term secular trends such as economic growth, global trade expansion, rising demand for commodities and the ongoing transition to renewable energy. These assets are considered core because they are “backbone” assets that operate on long-term leases to high credit-quality counterparties and are critical components of global supply chains. The long-term nature of the leases (in some cases, 15 years or more) makes an open-ended fund structure the preferable vehicle for accessing the market.
EXHIBIT 2: EXAMPLES OF TRANSPORTATION ASSETS
Although core transportation investments may be a relatively new asset class for institutional investors, the off-balance sheet leasing of transportation assets by large corporations is not new. The introduction of post-global financial crisis (GFC) regulations such as CRD IV, Basel III and Dodd-Frank, and their resulting regulatory capital constraints, drove traditional bank capital out of the business and created an opportunity for investors to access transportation as an asset class for stable income generation.
EXHIBIT 3: CORE TRANSPORTATION CHARACTERISTICS
Large assets critical to the global supply chain are placed on long-duration leases to high credit-quality counterparties
- End users view core transportation assets as essential components of their global supply chains and core operating expenses.
- Contracted revenue from long-term leases is supported by the counterparty’s balance sheet and, from a credit point of view, is the primary driver of highly resilient returns.
- Annual income generation is in the high single digits.
- Investors can access high quality credit and outperform fixed income and private credit yields by 400–600 basis points.
- Provides diversification in the drivers of return from real estate and infrastructure.
One of the key benefits of a core transportation strategy with an open-ended structure is that it allows a manager to spread investment activity across various subsectors. For example, challenges presented by the COVID-19 pandemic in 2020 created, and continue to present, significant headwinds in the aviation subsector, with many airlines experiencing liquidity challenges. The International Air Transport Association (IATA) estimates that global airlines experienced a 66% decline in revenue passenger kilometers and a total industry net loss of USD 118.5 billion in 2020.1 At the same time, the maritime subsector proved to be resilient, with global ton-mile trade down only 1.6% in 20202 and global port call volumes ending the year at roughly 99% of 2019 levels (Exhibit 4). Managers with diverse transportation allocations were able to shift capital deployment away from aviation and to the maritime subsector, where industry fundamentals remained strong. Those that had taken a disciplined approach to portfolio construction and diversification ahead of the pandemic were also rewarded with minimal or no impact to their fund performance from aviation exposure.
EXHIBIT 4: GLOBAL PORT CALLS (NO. CALLS, 7 DAY MOVING AVERAGE)
Global trade remained resilient in 2020 despite COVID-19 pressures
A compelling aspect of core transportation leasing is the high quality of the counterparties—often investment grade—that provide strong credit support during the duration of the leases, which can typically last from five to 25 years. “Take or pay” lease structures ensure that leases are supported by the corporate credit of the lessees, which have no ability to unilaterally modify or cancel the terms of the lease. The strong underlying credit support creates stable and visible cash flows, and builds resilience in the portfolio, mitigating exposure to market conditions
ESG in transportation: A risk or an opportunity?
In recent years, the transportation sector has made significant strides in the “E” component of ESG (environmental, social and governance). Over the past two decades, shipping volumes have more than doubled while emissions have grown by only 40%, thanks to major fuel-saving technological advances.3 A common misperception among investors is the impact transportation assets have on global emissions relative to the scale of their role in global trade. When broken down by subsector, ships produce only 2%–3% of total global CO2 emissions, even though more than 90% of global trade is carried by sea (Exhibit 5).4 This makes maritime shipping one of the most carbon-efficient forms of transportation, whether it is measured by units or by metric tons of cargo. Aircraft, which carry the vast majority of international passenger traffic and all air freight cargo, contribute only 2%–3% of total global CO2 emissions.5
Our Global Transportation Group has published a paper that delves deeper into ESG-aligned transport investing and explores how transportation can help investors achieve their sustainability goals.
EXHIBIT 5: TRANSPORTATION’S SHARE OF GLOBAL EMISSIONS
Maritime and aviation assets account for less than 5% of global emissions while moving over 90% of global trade
EXHIBITS 6A and 6B: GLOBAL SHARE OF ENERGY
Renewable energy has steadily increased its presence over the past decade and is on pace to surpass coal as the largest source of global energy production by 20406
Offshore wind-produced energy, generated by wind farms constructed in bodies of water, is projected to be the fastest-growing energy source of the next decade, with an expected increase seven times greater than current capacity (Exhibits 6A & 6B). Under the infrastructure plan proposed by U.S. President Biden in January 2021, 30 gigawatts of offshore wind capacity are projected to be installed in the U.S. by 2030. These wind farms would generate enough energy to power more than 10 million homes for a year, curb 78 million metric tons of CO2 emissions7 and create considerable demand for purpose-built wind-farm installation and maintenance vessels.
Wind farms are moving farther from shore and employing taller turbines. This creates a need for purpose-built service operation vessels (SOVs) and next-generation wind turbine installation vessels (WTIVs). The current fleet does not have the capacity to handle future industry demands and projected growth.8 This presents a significant opening to invest in next-generation transportation assets—and highlights ESG-aligned investments as an opportunity rather than a risk.
Despite ongoing progress in renewable energy adoption, a complete transition away from fossil fuel consumption will likely be a multi-decade process and require the use of interim “bridge fuels” such as liquefied natural gas (LNG). In his 2021 Annual Energy Paper, J.P. Morgan Asset & Wealth Management’s Chairman of Market and Investment Strategy, Michael Cembalest, evaluates several scenarios that could affect future U.S. demand for the natural gas used in electricity generation.9 His base-case analysis assumes a pace of wind and solar growth that falls between the current forecasts of the Lawrence Berkeley National Laboratory and the historical peak pace, and predicts natural gas demand in 2035 that is roughly unchanged from today. Even assuming a pace of wind and solar expansion that matches historical peak capacity, U.S. demand for natural gas in 2035 would decline by only 13% vs. today’s levels.9 This supports the outlook for transportation assets:
- Demand for natural gas continues to be driven by power plants switching from coal to gas.
- LNG offers emissions savings of roughly 20% compared with oil and as much as 50% compared with coal.10
- Global LNG demand is expected to reach 700 million tons by 2040, nearly double 2020’s 360 million tons.11
- Today’s LNG carriers can cost upward of USD 195 million apiece, and current forecasts indicate a need for more than 100 additional vessels to meet growing demand for LNG.8
The case for core transportation
Institutional investment in core transportation joins the long investment horizon of pension funds and endowments with an asset class that is exceptionally well aligned with their key objectives: total return, stable income and low correlation with other return-seeking strategies. In addition, core transportation offers a level of protection against inflation that is particularly valuable in today’s economic environment.
Finally, investors should step back and consider that these assets are part of a thriving global supply chain that is evolving to serve a more sustainable model of economic growth. Although the transportation sector includes some of the most mature industries and long-lived assets available to investors, it has been underrepresented in institutional portfolios. At a time when traditional investment strategies will be challenged to deliver, the benefits of allocating to transportation are at their peak.
1 International Air Transport Association (IATA) 2020 Annual Review, https://www.iata.org/contentassets/c81222d96c9a4e0bb4ff6ced0126f0bb/iata-annual-review-2020.pdf
2 Clarksons Research Shipping Intelligence Network, “Covid-19: Shipping Impact Assessment,” July 20, 2021, https://sin.clarksons.net/News/Article/163405
3 Shell, “Greenhouse Gas Emissions in Shipping,” https://www.shell.com/energy-and-innovation/the-energy-future/greenhouse-gas-emissions-in-shipping.html
4 Organization for Economic Co-operation and Development, “Ocean Shipping and Shipbuilding,” https://www.oecd.org/ocean/topics/ocean-shipping/
5 IATA, “Aviation & Climate Change Fact Sheet,” https://www.iata.org/en/iata-repository/pressroom/fact-sheets/fact-sheet--climate-change/
6 British Petroleum, “2020 Energy Outlook,” https://www.bp.com/en/global/corporate/energy-economics/energy-outlook.html
7 The White House, “Fact Sheet: Biden Administration Jumpstarts Offshore Wind Energy Projects to Create Jobs,” March 29, 2021, https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/29/fact-sheet-biden-administration-jumpstarts-offshore-wind-energy-projects-to-create-jobs/
8 Clarksons Research Shipping Intelligence Network, “Timeseries, Reports, Outlook,” July 20, 2021, https://www.clarksons.net/n/#/sin/timeseries/browse
9 Michael Cembalest, J.P. Morgan Asset & Wealth Management, “Eye on the Market: 11th Annual Energy Paper,” May 4, 2021, https://privatebank.jpmorgan.com/gl/en/insights/investing/eotm/annual-energy-paper
10 U.S. Energy Information Administration, “Natural Gas Explained: Natural Gas and the Environment,” https://www.eia.gov/energyexplained/natural-gas/natural-gas-and-the-environment.php
11 Shell, “LNG Outlook 2021,” https://www.shell.com/energy-and-innovation/natural-gas/liquefied-natural-gas-lng/lng-outlook-2021.html#iframe=L3dlYmFwcHMvTE5HX091dGxvb2svMjAyMS8