Infrastructure debt: Capturing the mainstream
Jerome Neyroud, head of infrastructure debt investments at Schroders Capital, on why infrastructure debt is no longer niche, the appeal of the asset class and the sectors poised to drive future demand.
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Q: Infrastructure debt has grown steadily over the last few years. What’s been driving this growth?
The real take-off of private debt in general – and infrastructure debt in particular – occurred after the global financial crisis (GFC), when banks pulled back from lending. This led to an increase in the spread, making private debt more attractive to institutional investors. Also, banks became constrained by regulation, limiting their flexibility and agility. This created an opportunity for new players, who were more innovative and filled the void left by banks.
Infrastructure debt has become mainstream and attracts investors of all types. There are three key reasons for that. First, in Europe, regulation for insurance companies is very favourable for infrastructure debt, with Solvency II offering a discount on regulatory capital for investors. Second, infrastructure debt provides long duration to insurers but now also offers shorter duration strategies attractive to pensions.
Third, in the growing context of ESG, it’s generally easier to implement ESG outcomes in infrastructure, such as in renewable energy projects, compared to direct lending.
Q: How have elevated interest rates impacted infrastructure debt?
Unlike other private debt classes, we can lend at either floating or fixed rates. If the rate is floating, we generally require the borrower to hedge by purchasing an interest rate swap to protect against rate increases. In areas like direct lending, for example, where the debt was not hedged, rising interest rates have deteriorated credit profiles.
Conversely, in infrastructure debt, our borrowers have been largely immune, and credit quality has remained stable. Why? Because this risk has been hedged from the beginning. Overall, while rising rates generally have a negative impact on credit quality, in infrastructure debt, they don’t, as we address and mitigate this risk before making the investment.
In terms of returns, the impact depends on whether the loan is fixed or floating rate. With floating-rate loans, higher rates mean higher returns. For fixed-rate loans, rising rates don’t increase returns – it’s all about asset-liability matching. For investors focused on matching assets and liabilities, fixed rates are beneficial even if they don’t capture the upside of rising rates. These investors are not speculating on rates but are focused instead on prudently matching their assets and liabilities.
Q: How has the expansion of the risk-return spectrum in infrastructure opened new opportunities for private debt investors?
The market has become segmented. Initially, we started with a one-size fits-all, long-term, fixed-rate investment model, with a similar risk profile (investment grade) to what banks were doing. This product was ideal for insurance companies due to its low risk and asset-liability matching characteristics.
However, other institutional investors, including pension funds, sovereign wealth funds and family offices, were less enthusiastic because infrastructure debt was too long term and low yielding for their needs. These investors, seeking higher returns and willing to take more risk, didn’t share the same investment needs as insurance companies.
This led to the market expanding beyond traditional investment-grade (typically yielding 2% over benchmark rates) to sub-investment-grade infrastructure debt with shorter durations (five to seven years) and higher spread, around 5% or higher over benchmark rates.
With today’s rates (around 3% in EUR and 5% in USD) combined with a 5% margin, sub-investment grade debt is not far away from the 10% ‘magic number’, approaching infrastructure core equity returns but with less volatility. This new product has been very successful since we pioneered it in 2017. We are now on the third vintage and continue to see strong investor demand.
So, today we have a credit continuum, offering various risk-return profiles, from long-term single digit investment-grade infrastructure debt to double digit sub-investment-grade options. Investors can choose the profile that suits them, either through commingled funds or segregated mandates.
Q: What’s your view on the current sector mix in infrastructure?
The market has certainly evolved over the past 30 years – slowly but significantly. For instance, 40 years ago, financing coal-fired power plants and oil pipelines was acceptable. Today, due to ESG concerns and common sense, it’s much less so. Thirty years ago, fibre optic didn’t exist, 20-years ago, renewables were barely on the radar, and five years ago, data centres were the new kid on the block. What were once considered emerging technologies, like data centres and fibre optic, are now mainstream infrastructure.
We are currently riding two major trends: digitalisation and energy transition. Digitalisation includes data centres and fibre optic, while energy transition encompasses not just renewables but also the entire value chain, such as electric vehicle charging stations and clean transportation, like electric trains for passengers and freight.
Q: How do investors differentiate infrastructure debt from broader private debt? And where does your strategy typically fit within their portfolios, from an asset allocation perspective?
Historically, investment grade has been a fixed income alternative, with sub-investment grade falling within investors’ infrastructure equity or direct lending allocation. Our focus has been educating investors and highlighting the attractiveness of this asset class compared to other alternatives.
When comparing infrastructure debt to direct lending, the distinctions are clear. Infrastructure debt is generally less risky, less volatile and offers access to unique sectors with essential assets, which direct lending does not. Additionally, while direct lending can compete with liquid broadly syndicated loans, infrastructure debt is a true private market with a handful of specialist lenders in Europe.
Infrastructure debt was yielding less than infrastructure equity until two years ago. However, with rising rates, infrastructure equity – like private equity – has struggled with distributing income, repaying investors and selling assets, leading to lower performance.
Meanwhile, the yield on infrastructure debt, especially sub-investment grade, has become more competitive against core/core+ infrastructure equity.
Q: Impact investing is a key focus for many investors. Is it possible to achieve strong returns while delivering measurable impact?
The low-hanging fruit to achieve impact is through renewables. The renewables sector is highly sought-after, meaning there is significant overall interest. Everything being equal, pricing is very competitive, so renewable financing is generally done on aggressive terms.
Some investors are willing to compromise on returns to achieve greater impact because it aligns with their internal objectives. Others, however, are less inclined to sacrifice returns. So, how do we achieve good returns while making an impact? There’s always the complexity premium, meaning it’s possible to pursue complex renewable deals and still achieve favourable returns. Additionally, we can look beyond the pure renewables segment.
Finally, you also need to consider the speed of deployment. If we aim for impact, the investment universe becomes more focused. This may have implications on diversification or pace of deployment.
This article was first published in Private Debt Investor, issue 118 "The Future Issue", November 2024.
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