This article is sponsored by HSBC Global Asset Management
Investor demand for infrastructure debt is ballooning as institutions seek yield, capital resilience and asset diversification in the wake of covid-19. With two new funds seeking to raise a combined $1.5 billion to invest across investment grade and subordinated debt strategies, the HSBC Global Asset Management Infrastructure Debt Investments team sees increasing appetite for higher yielding debt, as well as growing opportunity in emerging markets, say Glenn Fox, head of infrastructure debt investments, and Shantini Nair, senior product specialist for infrastructure debt investments.
What is driving demand for infrastructure debt?
Shantini Nair: Investors are drawn by the fundamental benefits of infrastructure debt, notably resilient cashflows in an uncertain and volatile environment, and the pricing premium to corporate bonds due to greater illiquidity and complexity. Pension funds and insurers are facing widening funding gaps in terms of the asset-liability mismatch and are witnessing significant volatility in their equity and fixed income portfolios. So, an asset class that presents resilient income without too much volatility – like infrastructure debt – fits the bill perfectly.
We are also observing that returns from some infrastructure equity programmes are converging with subordinated debt returns. That is partly due to increased competition in equity markets and market volatility. With lower risk than equity, subordinated debt is becoming more attractive to investors.
We tend to see investors split into two categories. One group is essentially looking for yield enhancement – either as a smaller allocation from their fixed income portfolio, or on an opportunistic basis. The other group is looking for a diversifier – an exposure that can complement their existing portfolio of growth equity investments.
“Pension funds and insurers are facing widening funding gaps in terms of the asset-liability mismatch”
How is the opportunity for investors evolving?
SN: Banks are retreating from certain markets due to regulatory constraints and the liquidity impact felt post-covid-19. This is most acutely seen in non-investment grade markets and it is leaving a lot of borrowers to fall back on non-bank financing. There is an opportunity to exploit that funding gap.
So, more generalists and established asset managers who have cut their teeth in the investment grade space are increasing their capital raising efforts in the high-yield markets.
In our case, we found there was a portion of our client base seeking much higher yields than could currently be provided by the investment grade markets, therefore our new launches have been framed to meet client demand for the best relative value that can be derived from investing across the capital spectrum, across both senior and junior infrastructure debt markets.
Which are the most attractive sectors currently?
Glenn Fox: We have invested our investment grade portfolios across a wide range of sectors – ports, toll roads, parking, liquified natural gas, conventional power generators, solar power generators, pipelines. We are quite sector neutral and prefer to look for a particular set of investment characteristics: long-term stable cashflows, underpinned by a contractual or regulatory structure that should protect the asset against the economic cycle. Revenues are generally fixed and not determined by volumes.
We recently looked at utilities transactions that typically are not attractive to us because of low yields. However, there was a period in March to May when spreads were higher. We also recently invested in a US healthcare asset because it offered a very attractive coupon for the rating level.
“Having an appropriate level of control if the deal runs into trouble is a key priority in due diligence”
Are there any sectors which investors should steer clear of?
GF: Covid-19 has taught many of us in the industry a harsh lesson about airport investment. We currently do not have any significant concerns about our limited airport exposure due to the quality of the sponsors and liquidity options open to the operators, but it would be difficult to put a new airport proposition to investors at this time.
We avoid coal-fired power generation and generally would not invest in the coal infrastructure chain, such as ports reliant on shipping coal. There are also thematic shifts to keep in mind.
For example, the European Investment Bank is no longer going to lend to gas-fired generation projects. That means we are wary of any future refinancing requirements and will only invest in investment grade debt for gas-fired power or LNG liquefaction if it is fully amortising.
We sometimes find that sponsors can get away with not offering the covenants we want, and we will walk away from deals that do not meet our structural standards. There is no amount of structuring that can mask a bad asset.
However, it is certainly possible to turn a good asset into a bad one through a deficient financial structure. Having an appropriate level of control if the deal runs into trouble is a key priority in due diligence.
How should investors look to approach emerging markets?
SN: In addition to the illiquidity and complexity premium available in infrastructure debt, it is possible to generate a country risk premium in emerging markets. Sponsors in emerging markets realise debt structuring is very important, so we often find emerging markets debt structures are more robust because sponsors cannot get away without offering some important covenants – as they might on the largest and most competitive deals in the US, for example.
The downside is that the deal could come under pressure due to the country losing its investment grade rating. As a result of covid-19, some countries – such as India – are teetering on the cusp of becoming high yield. India is likely to be a long-term success story because of its growth ambitions, its large population and low income per capita, but investors may have to endure a period of turbulence. One needs to be cautious about assessing the country’s economic outlook before deciding that the risk premium is sufficient over the weighted average life of the debt.
Things can change in emerging markets, as in developed markets. Our general starting point is the country’s history of accepting private sector investment.
We do extensive forensic due diligence, including advice from external advisers on risk management. Our teams also take a line of sight through to the underlying counterparty to make sure they have sufficient liquidity to cover the terms of the debt.
Where else are the opportunities for investors?
GF: Across Asia-Pacific we are seeing opportunities in Thailand, Indonesia and the Philippines. In Latin America, Chile, Uruguay and Peru are relatively attractive to us.
We are also looking selectively at the Middle East, where some countries, like UAE and Saudi Arabia, have quite robust credit ratings and some well-structured infrastructure projects. We are achieving a premium in markets that need more careful assessment of the geopolitical risks than some developed markets.
We are very focused on helping markets meet sustainability objectives for their economies by having access to investor capital and are working on ideas to bring financing to non-investment grade countries in Africa, Latin America and South-East Asia. We believe that we will be able to offer investors attractive means of investing in sustainable emerging markets infrastructure over the next few years.
How have infrastructure debt markets been affected by covid-19?
SN: Covid-19 has led to an unprecedented injection of fiscal stimulus, which has supported the functioning of the financial markets globally. This has created pockets of relative value in certain sectors within a number of both emerging and developed economies across the senior and junior infrastructure markets.
GF: Portfolio wise, we have not yet had a single asset that has gone from investment grade to non-investment grade as a result of covid-19. And where revenues have slumped for toll roads and airports, we expect those assets will return to something resembling normal in the future. They also have the ability to raise additional liquidity, either by raising additional debt or the sponsor injecting equity.
There was also a degree of disruption in the construction process due to the travel restrictions. However, overall, our portfolio has come through relatively unscathed, delivering yield premiums despite tremendous market volatility. And on the plus side, the blow out in spreads enabled us to make some investments on very attractive terms.
Building a focus on sustainability
How important is sustainability to investors?
Glenn Fox: We approach sustainability in infrastructure investing as a credit issue. We identify when environmental factors, in the widest sense of the word, could have an impact on the long-term stability of a potential investment, and we are seeing growing interest from investors on the environmental impact that our investments have.
We have not seen a strong drive from investors to invest in assets that are only sustainable, for now. Nevertheless, we think that this is coming and are assessing the potential launch of a sustainability-focused fund in the months to come.
How do you define sustainable infrastructure?
GF: HSBC is a lead participant in a global initiative which aims to bring some clarity to what is sustainable. It is much wider than looking at direct environmental impacts. There are social and governance issues too, and a lot depends on how an asset is being used rather than what it is.
Another thing we think is missing right now is sustainability reporting. It is not current market practice for a solar PV plant to report on CO2 emissions or environmental impact across its supply chain. But it will be in time and that will be a big part of making sustainable investment credible.
How should investors approach emerging technologies and themes?
GF: It is a tricky balance to strike. Due to the asymmetric nature of the asset class, we are instinctively risk-averse, so investing in new and untested technology is difficult. But if we can pinpoint technologies that are reaching commercial scalability then we would be interested. We are considering themes such as the charging of electric cars or the conversion of gas supply networks into hydrogen supply networks. We are also anticipating the emergence of new investment themes such as carbon capture and storage in the next few years.