Infrastructure debt’s resilience as an asset class was demonstrated during the pandemic. However, new challenges have arisen. A key concern for investors now is surging inflation, accompanied by rising interest rates.
Further fuelling uncertainties are concerns about an impending recession across Europe and globally. Hence the question for investors: Is European infrastructure debt an investment solution fit for the current environment?
A broad and diverse universe
The simple answer is yes, although investors need to consider that the infrastructure debt market offers a range of solutions with differing sector exposures (see Exhibit 1) and risk return profiles. This market is broad and diverse, with about EUR 310 billion in deal value in 2021, of which 70% was financed with debt.1
Overall, we believe the infrastructure debt market is well positioned for a recession. For the same reasons that helped it navigate through the pandemic: many infrastructure projects provide essential services that are mostly recession-proof.
Examples include projects in the renewables and power sectors – people require energy irrespective of economic conditions. Similarly, the telecommunications sector provides essential services including data and vital communication networks. In utilities, infrastructure projects provide important services such as water and sewerage facilities.
Another resilient sector that should be well placed to weather a recession is transportation: Rail and roads form the basis for the movement of people and goods. While the 2020 lockdowns hampered this sector, we have seen a recovery of deal flow.
For investors seeking long-term stable income, infrastructure debt is a resilient investment solution. However, what about those investors seeking higher yields or premiums?
Case for junior infrastructure debt
Soaring inflation has created a challenging environment for credit markets, with corporate bond yields rising significantly – euro BB rated corporate bond yields rose from 2.36% in February to above 5.50% in July.3 This has set up a potential dilemma for infrastructure debt investors seeking a yield premium over equivalently rated corporate bonds. This has largely diminished.
Junior infrastructure debt is a potential answer for these investors. It is an investment solution befitting the current market environment and outlook, in that it offers higher returns without overly extending risk.
We have seen European transactions with a 6.5% return. This is relatively attractive when factoring in the additional covenants and collateral compared to an equivalently rated European high-yield bond, which is unsecured and offers little (or no) covenant protection.
This segment is becoming more prominent. An increasingly competitive infrastructure equity market has pushed project sponsors to more sophisticated financing structures to reduce debt-servicing costs. This in turn has led to more tranching to target investors with different risk/return objectives.
Linked to this, infrastructure equity reserves have been growing significantly, pushing up the underlying equity prices. Equity holders are using junior debt to increase leverage and the internal rate of return. This segment is now well established in Europe and growing at a steady rate.
Notably, the segment is still relatively uncrowded as regulations (i.e. Solvency II Capital Charges) have so far enticed investors to focus on the senior (or investment-grade) end of the market.
From a pricing perspective, these regulatory constraints mean that junior infrastructure debt is not suffering the same competitive pricing tension as seen in the investment-grade space where banks and insurance companies compete fiercely.
Due to the increase in supply of junior debt and less investor demand, the junior debt segment now offers an attractive risk/return profile, including for many insurers after adjusting for Solvency II capital charges as well as for other investors seeking attractive yields.
Whether you are an investor seeking higher risk-adjusted returns, or one seeking a haven ahead of potentially challenging market conditions, we believe European infrastructure debt looks attractive.
As shown during the height of the Covid-19 pandemic, the asset class is steady and resilient, and backed by projects providing essential services. More recently, we have seen an expanding segment, junior debt, offering higher returns at a subordinated level while retaining debt-like protections.
Whatever the investment preference, European infrastructure debt can be seen as a compelling solution to weather oncoming storms.
This article was originally published in IPE Real Assets
1 Infranews, January 2022
2 ONS, Bloomberg, August 2022
3 Bloomberg, BaML Euro High Yield BB index, August 2022