Infrastructure debt has attracted growing interest from long‐term investors, particularly insurance companies and defined benefit pension plans.
- Infrastructure debt can offer a yield premium and diversification benefits
- This is a private market that requires specialist skills to assess risk-return
- We evaluate a solar farm portfolio as a case study
It offers a yield premium to public credit for investors able to bear the illiquidity of the debt. The premium is particularly attractive in the current low interest rate environment. It allows investors to gain exposure to assets that cannot be readily accessed via public markets, bringing additional diversification benefits. These long‐dated assets can be a good match for the long‐dated liabilities of insurers and pension funds.
Infrastructure projects such as toll roads, hospitals, schools, and energy infrastructure are essential to the social or economic well‐being of an economy or society. As a result, they can offer relatively secure income streams. With governments and companies increasingly looking to move financing of these assets off their own balance sheets, and with banks less willing or able to provide long‐term finance, asset managers have a growing role to play in supporting the financing of this much‐needed investment.
For insurers in particular, infrastructure debt can be capital‐efficient within modern solvency regimes in contrast to other alternative assets such as private equity and real estate.
Let’s use a renewable energy company as an example.
There’s a large renewable energy company that owns six solar farms. These farms benefit from a subsidy program that provides a fixed price linked to inflation for around half of the energy produced, with the other half of their electricity sold on the open market. Given the portion of inflation‐linked revenues, it made sense for the company to reduce the risk of their exposure to inflation by issuing both fixed‐rate and inflation‐linked debt.
This is typical of the structure we see in renewable debt financings, where companies seek to hedge their exposure to inflation.
Investors have the choice of investing in one or both, depending on what suits their liabilities. For many investors, the ability to match inflation‐linked liabilities is attractive as sourcing assets other than government bonds that are expressly inflation‐linked can be challenging.
As investors, we are attracted to an asset‐backed, fully-amortizing structure (where a portion of the loan is paid back each year) in this type of company. It is particularly well-suited to the matching‐adjustment portfolios we tend to manage for insurance companies, for instance.
The time until the loan is due to mature matches the timescale of the government‐backed subsidy, which means exposure to changes in power prices (historically volatile) is reduced. This matching of debt payments with underlying contracted cash flows is typical of major long‐term infrastructure financings.
The economics vary by market and sector compared to corporate bonds. In this example, investors in renewables debt received a yield of between 170 and 220 basis points (bps) above government bonds. This represents an illiquidity premium of between 20 and 70 bps relative to a general BBB rated corporate bond index.*
Additionally, recovery rates are usually significantly higher when things go wrong. Historical studies show that investors in infrastructure debt can expect to recover 70‐80% of their money in a default situation compared with typical rates of 30‐40% for conventional unsecured corporate bonds.
Associated risks also vary depending on the type of infrastructure investment. In this case, the debt is not typically rated by ratings agencies, so we have to do our own risk analysis. The primary risk with this company was energy generation.
If the energy generation forecasts are incorrect, the company will receive lower revenue, which may have an impact on debt repayment. However, we consider the full range of risks. The financing has to be structured to withstand severe downside in all of the risks, and this is reflected in our investment‐grade rating. Solar power generation is desirable regardless of geography because the panels are dependent on daylight, not sunlight.
Despite the risk, infrastructure debt remains an attractive investment.
Despite the risk, infrastructure debt remains an attractive investment. We expect investors to hold the debt to maturity. Currently, there is very limited secondary market liquidity in infrastructure debt. These are private market transactions, negotiated directly with the borrower, and there is a significant degree of complexity involved. But we expect liquidity to increase as the number of institutional investor allocations and investment to infrastructure debt continue to grow.
Diversification does not ensure a profit or protect against a loss in a declining market.
Standard & Poor’s credit ratings are expressed as letter grades that range from “AAA” to “D” to communicate the agency’s opinion of relative level of credit risk. Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories. The investment grade category is a rating from AAA to BBB-.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.