PATRIZIA on the endurance of high-yield infra debt

Throughout the economic cycle, high-yield infrastructure debt generates returns comparable with equity and with very low risk of loss, says Alexander Waller, head of infrastructure debt at PATRIZIA.

This article is sponsored by PATRIZIA

Alexander Waller

Why is infrastructure debt a good bet for investors right now?

Our market has several distinctive and appealing characteristics that are attracting increasing interest amongst investors. First, infrastructure debt is now seen as both mainstream and proven. PATRIZIA has been investing since 2000 and has generated an 8.5 percent USD return in that period, without a single default or cent of credit loss.

Investors now understand that infrastructure debt typically outperforms broad corporate credit in terms of credit losses. If you look at rating agency analytics for our asset class, you will see that rated infrastructure debt has outperformed similarly rated corporate credit. For high-yield infrastructure credit, where we focus, the outperformance is very significant.

One reason for this is that we lend to stable, cash-generative borrowers with inflation-linked revenues. These are businesses that hold steady value throughout economic cycles and, at a time like this, with rising inflation, infrastructure is a rare example of a sector that stands to outperform.

Another reason is that infrastructure deals have lower levels of refinancing risk. Our borrowers have long-duration cashflows and long-term borrowing available to them. That is particularly important as we enter a challenging period caused by inflation and rising interest rates, as well as the prospect of recession. Most infrastructure borrowers have taken the opportunity to raise long-term debt while interest rates were low. These are characteristics that are reassuring to investors – indeed, they can benefit via increasing rates that feed into their floating rate returns, even as other asset classes perform poorly.

Finally, the infrastructure debt market gives investors the opportunity to deploy capital in low-risk, sustainable assets. After all, infrastructure investment is driven by improvement and renewal: we invest in water utilities, renewable power, modular buildings and the development of fibre networks, for example. So, from an environmental, social and governance perspective, investment in infrastructure gives investors a rare and genuine opportunity to drive improved sustainability and efficiency.

And what makes the sub-investment-grade part of the market, where you operate, particularly attractive?

Our deals are strongly collateralised and current loan-to-values are often only 50-65 percent, as equity commitments to infrastructure assets have increased in proportion over time.

In the near term, high-yield infrastructure debt is likely to achieve returns comparable to core infrastructure equity, driven by the generally quicker pass-through of higher rates and risk premia to credit markets.

Return premia for high-yield infrastructure debt should also remain attractive compared to investment-grade senior debt, given the still much higher levels of liquidity in the senior market. We would expect little difference in credit losses between these segments, even in a recessionary environment, given the strong fundamentals (in particular, cashflow stability, inflation-linkage and moderate refinancing risk) that benefit all investors in infrastructure irrespective of seniority.

Is having a floating-rate approach also an advantage at the moment?

Absolutely. The past few months have been painful for fixed-rate investors. But we are not floating-rate investors by accident. This period of market stress was foreseeable, and our strategy has always been to enable investors to earn a safe, high-yielding return through thick and thin. We have prepared for a phase of rising inflation and increasing interest rates, and have deliberately positioned our portfolio to be focused on floating-rate investments. Our investors are benefitting from that.

Most institutional senior infrastructure debt is in fixed rate form. That is great for insurance companies that are matching assets and liabilities – it is sensible and necessary for them to invest in matched-duration fixed-rate debt. But for investors that are less focused on returns on capital and more focused on optimising risk-reward, the experience they have had in fixed-rate debt in recent months has been far from a happy one, as yields rise and valuations fall.

Have you seen spreads widening? How has your approach to assessing relative value changed in that context?

There has been upward pressure on spreads across the board, but the impact is more muted for high-quality underlying borrowers. For new deals in infrastructure, spreads and margins may be 25-50 basis points wider than in January. We look at relative value in the broadest way possible. We look at all spheres of public markets, of course, and are guided by them. We also look across the breadth of private markets and at where debt is priced versus equity, within and outside infrastructure. We look at where investment-grade debt is priced compared to high-yield debt to ensure we are achieving a comparatively attractive return on our investments. We don’t operate in a bubble. Pricing must reflect overall market conditions.

As private market investors we can afford to be nimbler and more bespoke. High-quality businesses will be able to access private capital through this stage of the cycle, even if public markets are closed.

“Borrowers may need to be prepared for more structured transactions and pricing may tick up”

How are you approaching the challenge of maintaining an appropriate illiquidity premium in this environment?

The illiquidity premium is only one component of our return. The more important component is the superior fundamental performance of infrastructure private debt when compared to more liquid asset classes. When we benchmark ourselves against high-yield bonds, for example, we find we have outperformed by between 100 and 200 basis points over 10-, five- and three-year periods.

Meanwhile, our outperformance against liquid leveraged loans is substantially higher again at between 200 and 400 basis points. Investors have been well compensated, not only for illiquidity, but also due to the fundamentally stronger credit quality of the underlying borrowers and the improved structuring and protection of our deals, at an attractive return that reflects the specialist skills needed to invest sensibly in high-yield debt.

What role do you believe private capital will play in the infrastructure finance market going forward, given the more challenging economic environment and increased volatility in public markets?

Private markets can be more discerning than public markets. We are already seeing borrowers and sponsors come to us with transactions that were originally earmarked as public markets deals, for the obvious reason that those markets are closed or that pricing has spiked, and so they are looking for alternative sources of financing.

Good deals should continue to attract financing from private lenders. Private markets are taking on a critical role in supporting financing within the infrastructure space. Borrowers may need to be prepared for more structured transactions and pricing may tick up. But good deals will still get done and we are eager to support high-quality borrowers.

There is substantial dry powder in the infrastructure debt space – is that likely to impact the availability of deals and ultimately returns?

There does seem to be a substantial amount of dry powder within the private infrastructure debt market. But while there is competition, there is also a lot of transaction activity and there are plenty of opportunities for managers to deploy capital today without chasing riskier investments.

Undoubtedly, there will be a reduction in liquidity going forward. Not all the capital that is classified as dry powder is truly discretionary and some of that will be the first to leave our market. We expect that competition will gently reduce and that will leave a strong pipeline of deals for investors, like us, that do have discretionary capital at their disposal.

What do you think it will take for an infrastructure debt manager to thrive through this turbulent period?

It is going to be a tough environment and that means that experience and sound risk management will become critically important again. We have just been through a lengthy bull market with falling rates, which has been forgiving to risky strategies. Those strategies are now going to be tested.

Managers like PATRIZIA that have been investing in infrastructure debt since before the global financial crisis and that have seen what can happen under challenging conditions will be in a stronger position. Having enduring access to capital is also important, and nothing will constrain investor enthusiasm and available capital-like investments performing poorly. There will be excellent opportunities ahead and those managers with clean, successful and lengthy track records will benefit.

Which sectors or geographies are delivering the most interesting opportunities for you right now?

We are essentially unconstrained on sector within the infrastructure space. We look for the best relative value, as long as the transactions meet the highest sustainability standards.

Nonetheless, at times like this, we will gravitate towards more traditional business risk profiles and capital structures that offer clear inflation protection and low levels of refinancing risk. In practice, that means increasing exposure to core infrastructure assets which are supported by, inter alia, regulation, long-dated contracts or monopolistic positions such as utilities or communications infrastructure.

At the same time, however, declining liquidity in the broader market should bring other sectors, such as renewables, back into focus. It has been difficult to find good relative value within the renewables sector over the past few years, given the enormous amount of money that has been chasing deals in that space. We are now starting to see better-priced transactions that are more conservatively structured.

Similarly, from a geographical risk perspective, we will continue to minimise our exposure. We have always focused on OECD developed countries with our infrastructure debt strategy and will continue to do so.