In focus

Senior infrastructure debt vs fixed income: which poses fewer challenges for investors?


The global economy has been badly hit by Covid-19, increasing credit risks and payment defaults for debt investments. At the same time, central banks across the globe have again provided strong support for financial markets, putting further pressure on interest rates and yields. The Financial Times recently highlighted that more than 60% of the global bond market now yields less than 1%.

The puzzle of higher credit risk and compressed returns means investors are struggling to find attractive returns while maintaining fixed income-like risk characteristics. In tackling the problem, we think many investors are overlooking European senior infrastructure debt, which is less exposed to some of the issues facing traditional fixed income.

Below the gaze of central banks

European senior infrastructure debt offers two key advantages for this market environment.

  1. Spread

Infrastructure debt is a private debt instrument, and therefore not eligible for central bank bond buying programmes. As a result, it is not exposed to spread compression driven by quantitative easing (QE). Instead, European infrastructure debt spreads are mostly driven by banks (which remain key players on this market) that add a margin to their funding costs.

Given the looming recession due to the current Covid-19 pandemic, it is likely that banks’ funding costs will remain stable or even increase. This is because they measure the overall credit risk assumed by banks, which is, in turn influenced by the expected default rate of their borrowers. In this situation in order to maintain a stable return on their capital, banks generally adjust their pricing upwards to compensate for the increase in funding costs.

  1. Reference rate

Public markets generally price over either Treasuries, -IBOR or “mid-swap”. In today’s European markets, all these reference rates are negative. Investors are then left with coupons lower than spreads. There is no such widely accepted market practise in European infrastructure debt. Lenders are often able to negotiate “zero floors” on reference rates (or trade a higher margin in exchange for reference rates with no zero floor).

As is shown in the chart below, senior infrastructure debt yield has indeed compressed over time, but at a slower pace than the fixed income market, thus increasing the relative value of senior infrastructure debt.

Yield_comparison_infrastructure.jpg

A record of resilience in crisis

Infrastructure debt’s status as a stable asset class has been documented over several decades - including during the global financial crisis (GFC) - by data from rating agencies. Senior infrastructure debt follows a similar expected loss pattern to A-rated corporates, while exhibiting a higher net spread.

The below chart compares infrastructure debt to other fixed income options, to see the difference in expected gross and net return. The red dot shows the expected gross spread, and the solid navy blue bar gives the expected return after subtracting historical losses. We can see that senior infrastructure debt has historically offered a unique combination of higher expected returns coupled with a low expected loss.

Net_spread_comparison_infrastructure.jpg

In addition to better expected losses than traditional corporates, senior infrastructure debt also tends to show less changeability in credit rating (“migration” ) and rating volatility. The below chart shows the percentage of downgrades for infrastructure securities versus non-financial corporates. As shown, infrastructure debt has been less susceptible to downgrades compared to non-financial corporates, historically.

Downgrade_probability.jpg

Past performance is no guarantee of future results.

But does this still hold true post Covid-19?

Initial feedback from market participants is encouraging. According to Moody’s Investor Services:

  • 66 corporate issuers defaulted versus just two infrastructure and project finance issuers (between March and May 2020)
  • Five infrastructure and project finance issuers defaulted (and no European names) in the twelve months ending 31 May 2020

Solvency II: the icing on the cake

In 2016 the European Commission recognised the features unique to infrastructure debt and approved a reduction in the Solvency II SCR (Solvency Capital Requirement) credit charge on qualifying infrastructure debt. The charge was reduced by around 30%, when compared to similarly-rated corporate bonds, providing regulatory capital relief to investors in senior infrastructure debt.

Solvency_cost_ratio.jpg

Conditions to remain tricky

We expect the environment of heightened credit risk and QE-led yield compression to persist. Investors face a difficult choice in seeking to replace the lost yield without meaningfully increasing risk. European senior infrastructure debt could offer an appealing “pick-up” for traditional fixed income allocations without introducing unnecessary risk, while adding sector diversification and reducing volatility.