How infrastructure debt can defend against The Zero
How infrastructure debt can defend against The Zero
The zero interest rate environment has had a range of effects on investor and market behaviour. We could point to the exuberance of equity markets, which are at or near all time highs. Or that almost a fifth of the global high yield bond market now yields less than 2%. We could cite numerous examples of traditional risk strategies failing to work as expected through bouts of high volatility.
Arguably though, one of the most significant effects of The Zero has been on the market landscape itself. The persistent zero-rate backdrop has carved out and broadened channels for investment that were previously the preserve of a few.
As pressures on traditional asset classes have intensified, the scope or breadth of assets considered by investors (particularly institutional) has widened into ever more specialist and esoteric areas.
Infrastructure debt is one of them. A relatively new asset class, it emerged in Europe in the aftermath of the 2011 – 2012 European sovereign debt crisis. Until then infrastructure debt finance had traditionally been provided by banks. But the tightening of banking regulations and requirements on liquidity has limited the traditional sources of financing, leading the market for private infrastructure debt deals to expand.
At its highest level, the market is split into senior and junior infrastructure debt. While there are characteristics unique to both the senior and junior categories, both offer tools to mitigate the effects of The Zero.
So, why does The Zero pose less of a threat to infrastructure debt than many other areas of fixed income? And where do we see opportunities emerging?
Infrastructure debt’s weapons against The Zero
Infrastructure projects are essential for the function, growth and prosperity of an economy. These projects are typically funded by both equity and debt. From the debt perspective, the tangible assets of infrastructure companies (toll roads, airports, bridges etc.) generate long-term cash flows, and these flows fund the coupon and principal payments to investors in the debt that is issued.
- Tailoring rate sensitivity
In terms of direct exposure to the interest rate environment, duration in infrastructure debt is limited by several factors.
It is not uncommon for contractual base rate floors to be built into the instruments themselves. Indeed, it is not unusual to floor the reference rate at zero. As a result, the more negative rates move, the greater the effective coupon you would be receiving on this particular loan (being the difference between base rates and your received margin). In other words, the value of the base rate floor becomes more impactful the further into The Zero we go, either in terms of rates falling further from here, or how long the policy environment lasts.
Investors can also adjust their rate sensitivity by making use of both fixed and floating rate infrastructure debt - both are commonly used within the structure of a given deal - and by varying the tenor (the debt’s lifespan).
Notably, the tenor for senior and junior debt are generally quite different. Senior debt is often longer in tenor and better suited to investors looking for very long duration assets. The junior debt part of the market tends to be shorter in term, with lower duration.
- Spread superiority and risk control
Infrastructure debt has a strong record of risk-adjusted returns when compared to traded debt instruments. We appreciate that “superior risk-adjusted returns” is a commonly (arguably over-used) term in asset management, but in infrastructure debt it can be demonstrated very clearly.
In simple terms, where default risk is comparable there is a prominent pick up in yield. In junior infrastructure debt, yield spreads can be similar or lower than comparable high yield debt, but crucially, investors take on roughly one quarter of the default risk. Although junior infrastructure debt shares characteristics with high-yield bonds rated BB, losses are a fraction of those on high-yield.
Risk adjusted return - how infrastructure debt stacks up
Source: Schroders, January 2021. Thomson Reuters Datastream, BofA Merrill Lynch, J.P. Morgan, Moody's: "Infrastructure Default and Recovery Rates, 1983-2015", Moody’s Default and Recovery Study 2017, Cass Commercial Real Estate Lending Survey, October 2018. 1. EUR IG over 6y IRS, USD IG over 8y IRS, USD HY over 5y IRS, GBP IG over 9y IRS, GBP HY over 5y IRS, Corp EMD over 5y IRS, Hard EMD over 7y IRS
The pickup in yield can be attributed to what is commonly called the illiquidity premium, but we feel is perhaps more accurately described as a “complexity premium”. The distinction is worth making, because the additional return is not purely due to capital lock-ups.
In a more recent development, it’s worth noting that demand for private debt has also been on the rise. This has worked in favour of particularly junior debt. As the amount of capital chasing infrastructure equity deals has pressured equity returns, it has brought junior debt into scope. The return differential between equity and junior debt has narrowed, while risk characteristics remain stable, and very much in favour of junior debt.
Many of the infrastructure deals we participate in are the result of a wide and established network of contacts, and being a trusted partner. Almost by definition, each infrastructure project is unique in its operational profile. In-depth knowledge of a variegated portfolio of assets is essential, and requires a great deal of analytical resource and hard-earned expertise.
Finally, but no small thing - as infrastructure debt is a private debt instrument, it is not eligible for central bank bond buying programmes. As a result, it is not exposed to spread compression driven by ongoing quantitative easing.
Focus on UK opportunities
A number of studies have demonstrated that Europe has a history of neglecting the maintenance of strategic infrastructure. Before the coronavirus crisis, European countries faced large funding shortfalls. These posed challenges in developing, maintaining and upgrading key infrastructure, but government efforts to mitigate the economic fallout of Covid-19 mean numerous infrastructure-focussed stimulus packages have been proposed.
The UK remains the most significant infrastructure market in Europe and we believe offers a huge array of opportunities for infrastructure debt investment. There was a wave of privatisations in the UK in the 1980s and 1990s which brought regulated infrastructure companies - providing essential public services across a range of sectors - to the market for the first time.
There are numerous significant targets for further investment in UK infrastructure in fulfilling pledges such as:
- Nationwide full fibre broadband by 2033
- Half of the UK’s power to be provided by renewables by 2030
- Investment of £43 billion of stable long term transport funding for regional cities
- Preparing for 100% electric vehicle sales by 2030
Stability and control
The infrastructure debt market presents investors with a valuable set of portfolio tools; adding diversified returns while tailoring risk in numerous ways. For investors in traditional fixed income, the risk-return profile of senior and junior infrastructure debt is enticing at the best of times. But from this zero-bound, and rate hikes unlikely to be even considered for another two to three years, we believe the benefits of and interest in the asset class are only likely to rise.
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