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INFLATION AND THE OPERATING PREMIUM

August 05, 2022 • By ITE Management
Disclaimer

This document contains information provided by several third-party sources not affiliated with ITE Management L.P. (“ITE”) that while believed to be reliable, has not been independently verified by ITE, and therefore, ITE makes no representation regarding the accuracy or completeness or that it represents the most up-to-date information from such sources.

Not for distribution or reproduction without the consent of ITE.

Container and Rail Car assets offer a hedge against inflation, because they command a wide, resilient spread over market interest rates.

Container and Rail Car gross yields are correlated to interest rates, but their excess spreads over those rates are not. Thus, container and rail car leases can provide an income stream that adjusts with interest rates but maintains a constant premium to interest rates. The reason for this resilience lies in the “operating premium”, or rail cars’ and containers’ utility as operating assets rather than as financial investments.

At ITE we are recently hearing inquiries from investors and prospects alike about the impact of rising inflation and the corresponding increase in interest rates on rail car and container yields. In response to these queries, we have analyzed historic container and rail car lease rates (for new assets) against several broad, fixed income market reference securities. 

This analysis interprets Container and Rail Car lease rates across three comparative metrics:

  • YIELD: historical lease rates vs. the five-year treasury
  • SPREAD: historical lease rate “spread” over the five-year treasury
  • CORRELATION ANALYSIS: historical lease rates vs. a high yield index
The strongest observable relationship with Container yields rest with the five-year treasury.

From 1995 to the first quarter of 2022, the correlation coefficient of quarterly yields between the two exceeded 0.7. However, correlation can be misleading. For example, an asset that maintains a static spread over five-year treasuries of 50 basis points will have a correlation coefficient of 1.0, or perfect positive correlation. So too will an asset that maintains an absolute consistent spread of 1,000 basis points. Even though both assets have the same correlation, an investor would almost always prefer the latter over the former because it generates significant income generated above the five-year treasury.

CONTAINER – YIELD

As a result, we focused our analysis on the spread over five-year treasuries generated by rail and container assets. Let us first examine container (20’ dry and refrigerated, or “reefer”) yields. Both container types exhibit a consistent and resilient spread over the five-year treasury.

20′ DRY SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

REEFER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

CONTAINER – SPREAD

The magnitude of the spread is clear from the graphs above, but a histogram analysis indicates the true range of the spreads. Both show a clear floor and reefers in particular exhibit a longer rightward skew.

20′ DRY SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

REEFER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

The next level of analysis looks to the true consistency of the spread over the five-year treasury. In other words, a spread that changes with the underlying reference security will exhibit high correlation but an inconsistent and unreliable income stream and greater duration risk. Investors would almost always prefer a security whose spread is consistent, wide, and uncorrelated with the broader interest rates.

CONTAINER – CORRELATION ANALYSIS

As the scatter plots below reveal, both dry and reefer spreads over the five-year are not correlated with the five-year treasury spread.

20′ DRY SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

REEFER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, Harrison, FRED

In other words, as the five-year treasury ranged from near 0% to almost 8% from 1995 to 2022, 20’ dry containers yielded a spread over them of 5-15% and reefers 5-20% with no discernible relationship between the five-year treasury and the premium generated by containers.

Rail Cars exhibit similar characteristics and for our analysis we focused on two prevalent types in North America (Tanks & Covered Hoppers)

RAIL – YIELD

TANK SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

HOPPER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

RAIL – SPREAD

The histograms below show a narrow band of observations, meaning that rail car lease yields are probably less likely to change as much as container yields. However, the rail car yields presented below may exhibit less variation because the data are annual whereas container data are quarterly. Annual data means a quarter of the observations of containers, which could lead to a narrower band.

TANK SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

HOPPER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

RAIL – CORRELATION ANALYSIS

Scatter plots for both new tank cars and hoppers show a slightly higher correlation to the five-year treasury as container yields.

TANK SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

HOPPER SPREAD OVER 5-YEAR TREASURY (1995-2022)

Source: ITE, RailSolutions, FRED

However, the histograms above also show that the absolute spread of new tank and hopper cars has consistently ranged between 8% and 10% and 6% and 10%, respectively. This is important, because if this historical relationship continues, we believe rail cars should generate significant excess returns over the five-year treasury as those yields increase.

No analysis of these niche assets can be complete without comparing them to broad, liquid, investable alternatives. 

The histograms below show the number of observations of High Yield Master II (HYM2) index compared to containers and rail cars.

DISTRIBUTION OF SPREAD: HYM2 & CONTAINERS (1996-2022)

Source: ITE, Harrison, FRED

DISTRIBUTION OF SPREAD: HYM2 & RAIL CARS (1996-2022)

Source: ITE, RailSolutions, FRED

These histograms show that most of the time from 1996 to 2022, high yield has generated a spread over the five-year treasury consistently lower (as seen in the clustering on the left of the two graphs) compared to rail cars and containers. Clearly there are fundamental differences between a high yield index and rail cars and containers. Liquidity is a key difference that springs to mind. It is easier to buy into a high yield mutual fund than it is to buy a rail car. Also, less capital is required to purchase one share in a high yield mutual fund than to buy even one rail car or container. However, for investors that have different allocations, accommodating liquidity budgets and sharper yield orientations, real assets can offer excess income.

We believe Container and Rail Car assets consistently generate a significant spread over market interest rates based on “operating premium” and the prevalence of leverage in the market.

Users of these assets, the lessees, value them for intrinsic reasons. Containers and Rail Cars are low-cost, critical assets in global supply chains. The essentiality of Containers and Rail Cars means that the cost of not having them when the business needs them is extraordinary. Logistics managers at the world’s largest agricultural, manufacturing, and shipping companies are focused almost entirely on making sure that goods are transported efficiently, safely, and on time. This creates a low-price elasticity of demand, enabling lessors to capture resilient income in container and rail assets over what can be generated in liquid financial assets like treasuries and high yield bonds. 

Lessors are able to raise lease rates in response to rising market rates, because the leasing industry commonly uses leverage. In order to preserve their own margins, lessors are forced to charge more for their assets when their own borrowing costs rise. The essentiality of those assets makes it difficult for lessees to resist price increases.

For investors with the right allocations and liquidity budgets, niche transportation assets could provide a solid, income generating, inflation protected income stream.

Niche transportation assets that are operationally critical such as Containers and Rail Cars have an intrinsic value that generates resilient demand from end users. That demand is seen in the wide spread over reference securities, such as the five-year treasury and the high yield index. Of course, that spread reflects other attributes, most notably illiquidity. Niche transportation assets exhibit a history of generating excess returns, where as asset owners can raise lease rates and generate income streams, protected against inflationary pressures.