The U.S Federal Reserve has indicated it will raise interest rates three times in 2018, following three rate hikes in 2017.
Short-term bond yields risen in anticipation of higher interest rates, decreasing the yield premium that some equities offer.
The shrinking yield premium may be a concern for investors in so-called bond proxy stocks; large, well-established companies with reliable earnings protected by high barriers to entry.
The prices of such stocks have been bid up significantly over the past few years as investors seek consistent yield in a low interest rate environment.
However, bond proxies may experience selling pressure now that major overseas economies are improving, and market commentators are also predicting an Australian rate rise later this year.
Infrastructure stocks can be heavily indebted due to the substantial cost of acquiring large assets like toll roads, and this is another factor to consider when rates rise. For example the companies may encounter higher interest expenses and costs to raise additional debt.
Below are two ASX-listed companies that have seen their share prices appreciate strongly over the last three years, but may not do as well in 2018 due to the expectation of higher interest rates.
Transurban Group (ASX: TCL) owns and operates toll roads around Melbourne, Sydney, Brisbane and Washington D.C. The company's shares have risen 33% since January 2015, though the current price is down almost 9% over the last month.
Transurban uses a large amount of debt to finance its operations, including borrowings of more than $13 billion as of 30 June 2017, equating to a debt to equity ratio of 3.
At its current share price, Transurban has a trailing price to earnings (P/E) ratio of 100 and yields about 4.50%, partially franked.
Sydney Airport Holdings Pty Ltd (ASX: SYD) shares are up 37.5% from three years ago and currently trade on a trailing P/E ratio of 46. The company also relies heavily on debt, with more than $8 billion of interest-bearing liabilities and a debt to equity ratio of 13.
Sydney Airport's earnings for the six months to 30 June 2017 rose 4.4% compared to the previous corresponding period. While this a good result, it's difficult to justify the company's lofty valuation on a P/E basis.
Shares in Sydney Airport are down 8% over the past month and pay an unfranked dividend of around 5%.
Foolish takeaway
Transurban and Sydney Airport are both great businesses with defensive assets that generate large cash flows. It's precisely these characteristics that have attracted yield-seeking investors, however I believe the shares may be fully priced at current levels.
Even when buying shares in great companies for the long-term, investors must still pay attention to fundamentals to ensure they are paying a fair price for expected returns.
