Infrastructure debt: ready to ride on the road to rising rates
Low levels of interest rates looks to be something of the past now as the Bank of England recently raised its interest rates for the first time in more than 10 years. The interest rate hiking cycle is already well underway in the US and while the European Central bank is likely to lag in terms of rate rises, less accommodative monetary policy is firmly on the agenda. The writing is on the wall, interest rates are on the rise.
Investors have thus begun to consider the impact of rising interest rates on many of their assets, including infrastructure. Infrastructure, which by definition provides essential services and possess long economic lives, is generally more resilient to broad macroeconomic movements than other more traditional asset classes. Infrastructure can be split into debt and equity and we believe that debt is the better choice within the infrastructure universe to weather an environment of rising rates.
Due to the essential nature of its activity, infrastructure companies tend to be more leveraged than corporates due to their less volatile nature. Debt in infrastructure projects is often 2-3x of equity within the capital structure and is also often portioned into senior and junior. Despite this, infrastructure equity has been the more popular choice with investors and the percentage of capital raised for debt investments only made up 10% of total capital raised in 2017. This certainly doesn’t correspond with the amount of debt required for financing infrastructure and, on the face of it, suggests that the debt market is less crowded than the equity market.
Capital raised in infrastructure (USD) in 2017 (as at 31 December 2017)
Source: Preqin, Probitas Partners, infrastructure Institutional Investor Trends for 2017 Survey – closed end funds, global.
Akin to any corporation, debtholders have to be paid before equity investors. Debtholders are then paid in order of their seniority, i.e. senior debtholders get paid their dues before junior debtholders. Each layer of the capital structure is compensated according to the risk taken. Senior debtholders, who have first claim on assets and cash flows generated by a project, have the lowest expected returns while equity holders, who only receive the residual income after all debt has been paid off, should generally expect a higher return. In addition, debt can be either floating rate, where the coupon paid is referenced to market interest rates such as the 3-month Euribor in Europe, or fixed rate, where the coupon is set at the outset and doesn’t change with changes in market rates.
Hypothetical infrastructure project
Source: Schroders, October 2017 – for illustrative purposes only
Using the aforementioned hypothetical project structure, we can see that 40% of the debt is floating rate (30% senior plus 10% junior). As interest rates rise, the total cost of servicing this floating rate debt will also increase. Equity holders will have to the bear the increase in this cost and this lowers their expected return. Additionally, an increase in interest rates implies that the opportunity cost for holding equity increases, further reducing the expected return for equity holders.
When we analysed the returns for the various segments of the infrastructure universe under different interest rate assumptions, we can visually see that the return to floating rate debt holders increases as the net amount available to equity holders reduces due to the increase in debt servicing costs. Furthermore, when interest rates reach 1%, junior floating debt could outperform equity on a cash yield basis. In other words, our example shows that interest rates don’t need to rise by that much for junior floating debt to become more attractive than equity.
Annualised returns over different interest rate scenarios
Source: Schroders, November 2017 – for illustrative purposes only. We assume all debt obligations are 10 year bullets (i.e. the full principal is repaid at maturity, in this case 10 years) and we assume that cash yield on equity is based on the residual amount available after servicing the previous debt layers. The analysis focusses on the cash return of the equity and doesn’t consider any gains that may be made upon sale at maturity. Annualised returns are over 10 years.
Interest rates would need to rise to over 3% for senior floating debt to start outperforming equity. This is expected due to the lower coupon rate that senior floating debt yields, to reflect the lower risk of this investment. Unsurprisingly, fixed rate debt holders are not impacted by changes in interest rates if their debt is held to maturity. In our illustration, senior fixed debt produces the lowest returns across the assets and scenarios, but at significantly higher interest rates, it could even outperform equity.
Whilst unlikely, there is always a possibility that interest rates may rise to high levels rapidly, which may even cause a default on infrastructure projects. Investors in infrastructure equity may be left with nothing if there is no capital left after all debt obligations have been repaid. On the other hand, infrastructure debt, specifically loans, are often secured and have many protective features which results in a lower probability of default for the asset class. Even in the event of a default, infrastructure loans have a much higher chance of recovering the principal compared to corporate bonds.
Infrastructure debt certainly looks to be the better choice to not just withstand, but to benefit from, rising interest rates.