The Appeal of Infrastructure Debt
The COVID-19 pandemic and the energy crisis both focused attention on the infrastructure industry, driving the ESG agenda and increasing investments in renewables. To minimize the negative impact of high interest rates, investors appear to be shifting their portfolios away from core strategies and toward higher-yielding core-plus strategies. Infrastructure debt is gaining popularity in this setting, owing to its relatively attractive risk-adjusted returns.
It is likely the space will see more capital concentration as larger firms pick up the bigger projects. On the other end many new players are coming to market with smaller funds and pushing for projects in emerging sectors.
In an economic landscape identified by heightened volatility, elevated interest rates, “sticky” inflation, and geopolitical tensions, infrastructure debt has proven to be an effective solution for investors seeking long-term income, stable cash flows, and diversification versus other asset classes, noted BNP Paribas Asset Management in a recent white paper titled “Investment Outlook 2024 – Stepping into a new reality.”
While M&A activity has slowed, the debt pipeline remains robust. BNP stated that it is witnessing a lot of refinancing activity as companies want to fund expenditure and greenfield projects.
Energy transition, sustainable transportation and digitization are driving demand, which will necessitate massive infrastructure investments around the world. As a result, the market appears certain to develop further in the years ahead, providing investors with a plethora of possible projects to finance.
“Limited lending capital further exacerbates the capital inadequacies across the transportation, utilities, energy and power, digital, and social infrastructure sectors located predominantly in the US and other OECD countries,” explained Michael Underhill, CIO at Capital Innovations and current ADISA president, to Connect Money.
“Capital Innovations assesses an attractive lending opportunity exists in the digital infrastructure sector today due to a supply/demand imbalance of capital, leading to pricing inefficiencies and enhanced ability for specialized lenders to negotiate terms and conditions,” added Underhill.
As infrastructure debt expands, a larger swath- from senior secured to more junior debt – becomes available, providing investors with more options. Given higher interest rates, infrastructure debt can now generate attractive absolute returns.
“Infrastructure debt can provide yield enhancement relative to public market fixed income, and resilient income with performance characteristics that are diversifying to other investment choices such as public bond markets and equities,” Underhill said.
Returns in the junior debt class are at “core infra equity-like levels”, according to BNP, implying that reallocation into the asset class may be a long-term trend. Meanwhile, senior debt’s positive illiquidity premium means it remains an excellent alternative to traditional fixed income.
“There will be an increased need for refinancing in infrastructure financing over the next two years, as many debt instruments are due to expire. Interest rate premiums – 25 to 50 basis points higher for senior bonds and 50 to 75 basis points higher for junior bonds than before the Russia-Ukraine war – are currently attractive,” said Jessica Hardman, head of European real estate portfolio management, DWS.
BNP believes the infrastructure debt market has reached a “turning point,” with investors progressively shifting to low-carbon projects as the need for private capital to achieve net-zero goals. These assets’ sustainability and climate change features appear poised to be major investment criterion in 2024.
Renewable energy is an important piece of the equation, but decarbonization of all infrastructure assets, from transportation to the elimination of coal in the utility mix, is required. According to BNP’s analysis, the first carbon capture and storage projects are approaching the market for finance, with potential seen throughout the battery storage technology and green hydrogen value chains.
Along with rising investment in the transition to a low-carbon economy, the infrastructure debt market is experiencing fast product innovation. Managers are increasingly developing thematic funds focused on specific sectors and investment themes, while increased availability of debt in the sub-investment grade segment creates an opportunity to finance assets with some development risk rather than only ready-to-build projects.
“The asset class has historically experienced lower probability of default and higher recovery rates compared to rated corporate credits based on publicly available research from Moody’s Investors Service, Inc., noted Underhill. “We believe these characteristics make the sub investment-grade infrastructure debt universe an attractive area for institutional investors with long term capital to find relative value and generate attractive risk adjusted returns.”
Lenders who can analyze the entire value chain, from technology to market research to income generation, and offer bespoke financing solutions that align with emerging business models, will be able to invest more proactively and capitalize on early-stage opportunities with the best risk/return ratios, noted BNP Paribas.
As we approach 2024, the contracted revenues, strong regulation and inflation pass-through characteristics of infrastructure debt likely mean the asset class is well-placed to handle continued uncertainty.
