After what feels like three years of perpetual crisis, investors are asking what inflation, the energy crisis and rising interest rates mean for infrastructure debt. The good news: the asset class will continue to play an important role.

Central bank behaviour

The past decade has been characterised by loose monetary policy. This is now over. Now that the European Central Bank will no longer act as one of the main buyers of new capital market issues, this will reduce the pressure on credit margins. With increasing capital requirements for new infrastructure projects, higher margins and fewer financing options from banks, there should be more attractive opportunities for institutional infrastructure debt investors.

Stress in the system

“As a defensive
asset class,
infrastructure debt
should be well
prepared to deal
with ‘stress in
the system'”

Credit markets are nervous and spreads are fluctuating. Currently, some investors are shifting from high yield to investment-grade asset classes such as infrastructure debt, considered one of the most conservative segments of corporate bonds. We are not yet seeing the market transform from a borrower’s to an investor’s market. The relative advantage has shifted to the detriment of equity and in favour of debt.

While investment-grade infrastructure bonds yielded between 1.5 and 2 percent in 2021, they now yield around 5 to 5.5 percent. Core infrastructure equity came in at 8 to 10 percent. That level of return can be achieved today with high-yield infrastructure bonds. In general, as a defensive asset class, infrastructure debt should be well prepared to deal with “stress in the system”, as the chart opposite shows.

M&A slowdown

The M&A market has slowed significantly. Buyers and sellers of companies no longer seem to ‘speak’ the same language. Enterprise value multiples have come down, but most asset owners are not yet willing to sell at these new lower prices. As a result, capital markets are providing less acquisition financing opportunities.

However, this is partially offset by the pent-up demand for infrastructure. That’s why we are currently experiencing a higher number of tenders seeking funding. Many countries must and will invest in critical infrastructure in particular, but they are under budgetary pressure. Private investors can make an important contribution here.

Digitalisation

Several countries have stepped up their efforts to roll out fibre, attracting the interest of institutional investors. Most of these investments are riskier due to the high investment requirements and their relatively low realised EBITDA. In most cases, the expansion involves greenfield projects. In addition, many market players are in fierce competition, highlighting the complexity of this young asset class. Once the roll-out of fibre is complete, we expect fibre networks to become a key asset class that is attractive for long-term financing.

Renewables only?

With the goal of reaching net zero CO2 emissions by 2050, investors are rushing to renewables. As a result, they are the least attractive asset class from a risk-return profile. But wouldn’t it be more meaningful to finance the transition of ‘dirty’ plants, using tough covenants that require emissions reductions?

Another area with potential is in emerging asset classes such as storage, hydrogen and carbon capture. There is not much to be found in the credit markets for these asset classes yet, partly due to the lack of regulatory frameworks. We expect this to change. Initially, opportunities will be within blended finance structures or export credit insurance cover, but later also as traditional project finance.

Financing conditions remain challenging, and banks are still the largest provider of infrastructure financing. However, the combination of reduced central bank support for banks and potential stress on banks’ balance sheets due to higher defaults may change this and improve the environment for institutional investors. There is huge demand for infrastructure finance.

The EU Commission presented its Net Zero Industry Act in mid-March and a main objective is to build key green industries in Europe. The production capacity targets for strategic technologies such as batteries, electrolysers, photovoltaics, carbon capture, utilisation and storage require significant investments not possible without infrastructure financing. Experienced institutional investors can seize on infrastructure debt opportunities that might benefit their portfolio as well as social and economic development in Europe.

Claus Fintzen is CIO of infrastructure debt at Allianz Global Investors