BNP Paribas AM: Can infrastructure debt continue to deliver?

Amid fears of recession, BNP Paribas Asset Management’s Vincent Guillaume and Timothy Li assess the outlook for an asset class that has proven its resilience over the past few years

This article is sponsored by BNP Paribas Asset Management

Vincent Guillame

Even as the pandemic and subsequent lockdowns prompted an unprecedented economic slowdown, infrastructure debt has delivered attractive yields and stable income streams. While the listed bond and equity markets struggled with volatility, European infrastructure debt investments rode out the storm with comparative comfort.

With the conflict in Ukraine and concerns around energy security in Europe, investors now face the new challenges of higher inflation and rising interest rates. This has produced negative returns across bond and equity markets and raised fears of an impending recession in Europe, the UK and US.

The question for investors is whether infrastructure debt as an asset class can continue to deliver in this increasingly uncertain economic climate.

Timothy Li

The simple answer to the question is ‘yes’. The salient features of the infrastructure asset class underpinned by stable, inflation-linked cashflow over the long term make these debt instruments well positioned to navigate any downturn in the economy, offering effective protection against inflation for investors. Also, many infrastructure lending options include floating rate instruments, which can be more attractive than fixed income options in the current climate, as the income received is linked to the base rate, so can increase in an environment in which interest rates are rising.

However, it is important to stress that infrastructure debt remains a broad and diverse investment universe, covering a range of investment solutions and strategies with varying risk-return profiles. Investors must ensure they invest in the appropriate segment and sector of this market to meet their objectives.

Resilient income streams

The European infrastructure debt market has grown significantly in recent years. In 2021, about $310 billion-worth of deals were arranged, 70 percent of which were financed through debt arrangements, as reported by Infranews.

Primarily, these infrastructure deals finance essential services straddling a wide range of sectors including energy, utilities, communications, transport, education and healthcare services.

From an investor’s point of view, these defensive sectors are especially attractive during periods of higher inflation, or recession, as demand is likely to remain, regardless of any economic downturn.

In other words, people might cut back on discretionary spending when times are tough, and this will affect profitability in those more cyclical sectors. But they will still need to use broadband services, rail networks, energy to heat and light their homes, and education and healthcare facilities.

Many of these infrastructure projects support the transition towards a lower-carbon economy to meet net-zero goals or the digitisation of key industries, driving demand for greener energy and digital assets and providing exciting long-term growth prospects for the asset class.

Infrastructure debt offers investors the opportunity to participate in the funding of these multi-billion-euro projects that provide a reliable income stream to investors over the medium to long term.

Opportunities in junior debt

Over the past 10 years, infrastructure debt has offered consistently higher yields than the bond markets.

This is partly due to the ‘illiquidity premia’ – the additional return offered to investors for forgoing the flexibility of fixed-income investments listed on publicly traded markets. This differential widened over the past 10 years, as ultra-low interest rates pushed corporate bond yields down to record lows.

But while returns on infrastructure debt have remained fairly consistent of late, rate hikes by central banks in Europe, the UK and US have given yields on government and corporate bonds a boost. Euro BBB corporate bond yields, for example, rose from 1.4 percent in February to over to 4.7 percent in mid-October 2022, according to Bloomberg.

For investors seeking a relative yield premium (to equivalently rated corporate bonds) the choice between these two asset classes has become less straightforward.

Luckily, infrastructure debt is a mature and diverse market, offering a broad range of risk-return profiles. In this context, junior infrastructure debt, which delivers higher, equity-like returns while maintaining debt-like protections and not over-extending on risk, is one attractive option for these investors.

Several European junior infrastructure debt investments now offer returns of more than 7.0 percent, while featuring covenants, underpinning collateral and a large amount of equity reserves as downside protections.

This makes junior debt an increasingly attractive option in the current market. Unsurprisingly, it has been a growing segment of the infrastructure debt market over the past year.

Demand from investors has created more competition across the infrastructure market. Project sponsors have become more sophisticated in their financing structures, to reduce debt-servicing costs. This had led to a wider range of debt tranches being issued, designed to appeal to specific segments and distinct risk-return objectives among the wider investor community.

Linked to this is the fact that infrastructure equity reserves have been growing significantly – pushing up underlying equity prices. Equity holders are using junior infrastructure debt as a mechanism to optimise their capital structure and increase their internal rate of return. The junior debt segment of the market is now well established in Europe and growing at a steady rate.

Despite growth in infrastructure debt as a whole, the junior debt segment remains relatively uncrowded. This is in part due to regulatory changes, and the Solvency II capital charges, which to date have enticed investors to focus on senior or investment-grade debt. Junior infrastructure debt has so far escaped this competitive pricing tension, whereby banks and insurance companies compete heavily to buy up investments – pushing up prices and driving down equity yields.

An increase in supply of junior debt, coupled with more muted investor demand, means the junior debt segment of the market offers a highly attractive risk-return profile. This appeals to insurers who may need to adjust for Solvency II capital requirements, as well as other investors seeking higher yields in the current climate.

This is not to say that the senior debt market should be overlooked entirely. Although the pricing in this area remains challenging, particularly in the current climate, it offers stability and resilient returns for investors in need of secure income throughout the economic cycle.

Notably, while the illiquidity premiums have declined since early 2022, there has been a recovery throughout the past few weeks, following a softening in spreads in the public market as well as repricing activity in the private markets. Currently, we are observing illiquidity premiums of senior loans at around the 20-50 basis point range. Moreover, we expect performance to be further supported by the floating rate instruments as interest rates continue to rise.

Challenges ahead

No one can pretend everything will be plain sailing in the financial markets. The infrastructure debt market faces its own particular challenges: the rising cost of raw materials can have a direct impact on construction costs and may affect returns on new issues going forward. At the same time, the increased cost of energy may also affect the operating costs of projects, while higher costs of debt may pressure their cashflow generation.

Despite these challenges, this remains a buoyant sector with a strong pipeline of transactions looking to come on stream over the next six months to a year. This will create opportunities for investors, whether they are looking for higher returns at a subordinated level, or the reassurance of investment-grade opportunities.

Experienced infrastructure debt managers will, before investing, analyse a wide spectrum of factors that might affect long-term asset performance.

In considering the core fundamental strengths of the asset class, European infrastructure debt represents a compelling solution to help investors manage the inevitable market challenges that lie ahead.

Strength in diversity

Infrastructure debt holds the key to numerous scenarios

A key consideration for infrastructure debt as an investment solution is the innate diversity within the asset class, covering not only the seniority within the capital structure but also the broad range of sectors. This is because the multiple sectors and segments may often perform differently to market conditions, as witnessed through the geopolitical and inflationary concerns experienced from March onwards. An example of the performance dispersion is evident through the recent repricing of various infrastructure debts.

While from a high level infrastructure debt repricing has been so far limited, we have witnessed a divergence in repricing activity based on segments and sectors. There has been limited repricing for investment-grade senior tranches, whereas we have witnessed higher repricing for subordinated/sub-IG tranches. Particularly for the senior segment of the market, the relative pricing stability is largely explained by the resilience of the asset class and the recent flight to safety from investors.

Furthermore, infrastructure debt projects have experienced different repricing based on their respective sectors and geographies. On the back of the energy transition trend, renewable and green assets continue to perform and be in demand, resulting in little to no repricing activity. These renewable and green assets are set to receive further support following the conflict in Ukraine as European countries seek to reduce dependency on Russian-sourced energy.

A similar pattern has emerged for telecom infrastructure, given the support of the digitisation trend, its contribution to resilient performance and only marginal repricing.

In fact, most repricing activity witnessed has been in non-green sectors with greater demand and/or market risk, or geographies with relatively higher levels of political instability and inflationary pressure.

A strength of infrastructure debt has always been its diversity across multiple sectors and segments, and investors who consider this will likely reap the benefits, be it greater security or returns.

Vincent Guillaume is investment director, infrastructure debt and Timothy Li is head of investment specialists, private markets at BNP Paribas Asset Management