In many respects, infrastructure debt has been a resounding winner in the maelstrom of spiralling inflation and rocketing interest rates that have dominated the macroeconomic backdrop in recent months. Returns that sometimes appeared lacklustre when rates were at rock bottom are now providing an interesting alternative to equity from a risk/reward perspective.
“The asset class has been at the lower end of the return spectrum for many years due to low interest rates. But now that rates have normalised in the 4-5 percent range, we are seeing returns in the high single digits to low double digits,” says Jeffrey Griffiths, co-head of global private credit at Campbell Lutyens.
“That is making infrastructure debt a lot more appealing to institutions such as pension funds and insurance companies that have liabilities that require them to generate high single digits regardless of where interest rates are.”
Griffiths adds that he is seeing capital being redirected from traditional core infrastructure equity allocations, as well as private credit allocations that are typically more geared towards corporate private credit. “We are also seeing some activity coming from fixed income portfolios as investors seek illiquid strategies in order to achieve higher returns than they are able to achieve with their liquid portfolios.”
“Even investment grade credit can now get you to 6 or 7 percent, which is a far cry from where we were a few years ago,” adds Pieter Welman, head of global infrastructure at Barings. “And a lot of people are now looking to high yield as an alternative to equity. There has definitely been an uptick in demand for infrastructure debt as a result.”
Griffiths agrees that high-yield strategies, in particular, are commanding attention. “Sub-investment grade, double B equivalent risk is where we see most interest at this stage,” he says. “The investment-grade market is still relatively low-returning and so isn’t necessarily the right fit for all institutions.”
Meanwhile, returns are not the only draw that infrastructure debt offers.
“Now that rates have normalised in the 4-5 percent range, we are seeing returns in the high single digits to low double digits”
Jeffrey Griffiths,
Campbell Lutyens
“We see global mega-trends in digitalisation, energy transition, and transportation and mobility driving demand for infrastructure – and infrastructure financing,” says Patrick Trears, head of infrastructure debt at Ares.
“Infrastructure debt can also provide important portfolio diversification among other credit exposure, particularly since the infrastructure market has historically experienced lower volatility and default rates relative to other asset classes. Indeed, when markets are volatile as we have seen in the last 18 months, investors see infrastructure debt as a flight to quality with strong downside protection.”
Structural resilience
Robust LP appetite is supported by the healthy performance of existing infrastructure debt portfolios, since most loans involve floating rate instruments based on appropriate benchmarks.
“Our team also typically negotiates interest rate floors as part of the transaction structure, in order to protect from downward movement,” says Trears. “So, in a rising rate environment, we expect the portfolio to directly benefit from base rate increases. While a prolonged increase in interest rates may impact borrowers, we remain comfortable with coverage ratios for transactions within our portfolio and with our borrowers’ ability to service debt cashflows.”
Furthermore, interest rate hedging requirements in loan agreements protect borrowers from movements in the base rate while providing lenders with the upside potential. Ares, for example, typically looks for a minimum hedge ratio of 75 percent of interest. Meanwhile, infrastructure itself is relatively immune to the surge in inflation that led to these interest rate rises in the first place.
“As a source of relatively stable, indexed cashflows, infrastructure assets can potentially act as both an income asset and an inflation hedge – qualities that are especially attractive in a high-inflation environment,” says Trears. “They can also be resilient during economic downturns with particularly defensive characteristics that have made this asset class durable in almost all conditions.”
While there are exceptions, inflation-correlated revenues are typically integral to the definition of infrastructure. The right to increase revenue by inflation is often embedded in concession agreements and licences, and this linkage sustains margins through inflationary periods because of various in-place protections.
Furthermore, infrastructure assets typically have low correlation with other asset classes and economic output due to inelastic demand. Infrastructure assets provide essential services with fundamental importance to consumers in everyday life.
“In 2022, rising global inflation and interest rates resulted in meaningful negative pressure across bonds and public equities,” Trears says. “Infrastructure assets performed better on a relative basis. Infrastructure investments can therefore help with portfolio diversification for investors building portfolios across asset classes.”
Welman, however, says that while positive inflation correlation is undeniable, the asset class is not entirely immune to the broader macro environment to the extent that inflation slows down the economy, causing major projects to run into trouble. “And while interest rate increases have been positive in terms of increasing yield, they have also increased refinancing risk. Nonetheless, I still believe that infrastructure is better insulated than pretty much any other sector.”
Decreased deployment
When it comes to new deployment opportunities, the infrastructure debt world has been impacted by the overall slowdown in M&A activity. “The market is more subdued, particularly when it comes to M&A,” says Welman. “We are seeing less activity compared to recent years as participants adjust to the new reality.”
Furthermore, with the cost of debt up considerably, where acquisitions are taking place, debt multiples are lower. “There is a definite recognition that no one knows how long this higher rate environment will last, and so debt structures are tighter and less leverage is being employed,” Welman says.
The same is true in greenfield or expansion situations, where debt is increasingly being switched out for equity. “We are certainly seeing less debt going into digital infrastructure and transition roll-outs than we would have done a few years ago,” Welman adds.
While demand for debt is diminished, so too is supply, which has helped bolster deployment opportunities for those whose appetite remains. “Banks are becoming more and more constrained in terms of risk tolerance and even asset classes such as infrastructure debt are falling from favour due to pressure on bank balance sheets as a whole,” says Griffiths. “As a result, we are seeing opportunities for private funds to replace banks as providers of capital.”
Trears adds: “Infrastructure financing has historically been the domain of public spending and bank financing. As the syndicated loan and high-yield bond markets have been less active, there is a continued shift from traditional sources of capital. This creates a compelling opportunity for direct lenders to meet borrowers’ needs.”
The other advantage infrastructure debt has in its favour, of course, are the powerful megatrends that underpin investment theses. “Across developed economies, growth in infrastructure is expected to be spurred by themes in digitalisation, decarbonisation and increasingly complex global supply chains,” says Trears, noting that global demand for connectivity, alongside increasing computing needs, has driven growth in telecommunication and 5G infrastructure.
“Data centres, for example, are a growing sector capturing the attention of many infrastructure debt providers. Many digital assets, including data centres and telecommunications assets, have a natural downside protection given they are necessary for most societies today.”
“There is a definite recognition that no one knows how long this higher rate environment will last, and so debt structures are tighter and less leverage is being employed”
Pieter Welman,
Barings
Trears also points to the build-out of alternative energy sources as more and more countries set net-zero emissions targets and as the demand for more robust transportation infrastructure for the movement of goods and people rises due to an increasingly mobile population and changes in consumer behaviour.
There are some sectors where lenders remain cautious, however.
Welman says: “There have been some well-publicised challenges around certain fibre roll-out projects, for example. And there were some areas around transportation where people were wary a few years ago, although I think that as confidence in the economy is restored, lenders are more open to those transportation assets once again.
“I don’t think there have been enough long-term social infrastructure opportunities around to gauge appetite there. Duration had been an issue, but that now seems to be easing. But I think it is the energy transition that is really garnering attention. While there was a bit of a pause last year, there are some really exciting projects in the market right now.”
Griffiths, meanwhile, points to the scale of both equity and debt capital required to fund the energy transition, while also alluding to a proliferation of dealflow in the digital, transportation and municipal district heating spaces. “There are a wide variety of infrastructure assets that require debt financing, and most funds are spreading risk across the spectrum. But energy and power are certainly commanding the most attention, and that is one area where investors often choose to go with a specialist rather than a generalist manager.”