Over the past 12 months, the war in Ukraine and interest rate hikes have caused significant volatility in financial markets. Rising rates, geopolitical instability and an uncertain economic outlook have increased yields, albeit inconsistently, across debt products and markets.
Leveraged loan and bond markets have been the most significantly impacted: in Europe, volumes are down around 67 percent in 2022, compared with 2021. European infrastructure debt, meanwhile, has fallen around 14 percent, with a more benign outlook for borrowers.
With rates likely to remain elevated amid ongoing macroeconomic uncertainty, infrastructure debt is currently at its most attractive since the global financial crisis.
Firstly, infrastructure assets offer long-term, stable cashflows with revenues that typically benefit from inflation. The floating rate nature of infrastructure debt means investors are picking up yield due to rising rates, with EURIBOR around 3 percent higher than a year ago.
Spreads for private transactions have also increased, albeit at lower levels compared with leveraged markets, reflecting the lower risk of lending backed by real assets. This increase in spreads and rates feeds directly into IRRs for private infrastructure debt investors. We are now expecting returns above 8 percent for our high-yield infrastructure debt strategy, which offers a substantially better return for risk than other debt and equity asset classes.
Doing well, doing good
Despite growing volumes, the infrastructure debt market has maintained discipline in structuring and leverage, with gearing levels often around 50 percent. While infrastructure lending is cashflow-driven, such equity cushions provide material downside protection.
Infrastructure loans typically also include maintenance covenants and lock-up tests to protect cash leakage in the event of underperformance. Conversely, leveraged loans and high-yield bonds have been increasingly structured on a covenant-light basis, with minimal protections for lenders.
Finally, infrastructure debt is a natural home for investors looking to make sustainable investments. The sector has the potential to contribute towards climate change mitigation and the energy transition.
A growing number of investors are seeking to deploy capital with managers whose funds have a minimum percentage of EU Taxonomy-aligned investments.
We expect this trend to continue, with investors scrutinising ESG policies carefully – the days when managers could credibly invest in coal mines via one arm of their business while singing about their green credentials in another are likely to be coming to an end.
The sustainability characteristics and excellent risk-adjusted returns underpin the attractive investment case for infrastructure debt, with relative value firmly skewed in its favour –today’s market opportunity offers a compelling entry point.