The feeling of rising interest rates is becoming all too familiar. In the first week of February, the US Federal Reserve, Bank of England and European Central Bank all raised rates. The Fed target rate of 4.5-4.75 percent is the highest since the global financial crisis. However, forecaster Oxford Economics expects rates to peak in 2023, partly off the back of some more encouraging positive economic data and lower energy prices.
Wearing my infrastructure debt hat, the expected total return of 10-year European infrastructure debt has increased by 3-4 percent since the start of last year. This makes the asset class more appealing for total return investors, especially those focused on yields.
Infrastructure debt providers should now be targeting returns of approximately 5 percent for investment-grade debt while high-yield ranges between 6.5-8.5 percent, depending on the credit quality and subordination of the instrument. These returns look attractive, especially when compared with core infrastructure equity, where we see some downside valuation risk.
From an infrastructure equity perspective, the era of ultra-cheap money is over. Historically, the performance of the asset class has been strongest when real rates are declining, suggesting some headwinds for valuations. We think that core equity assets are the most exposed given the relatively low return premium over government bonds, although assets with strong inflation pass-through will remain in high demand.
Pardon the delay
We also see some pressure on opportunistic strategies, especially those with large pipelines and low visibility on cashflows. These businesses are exposed to supply-chain issues, higher costs and the availability and cost of financing. Core-plus and value-add strategies should cope better as they tend to use less leverage and target higher returns that can tolerate higher financing costs.
To date, we have seen robust infrastructure equity returns and little valuation impact. This may be because infrastructure is seen as a defensive asset class that has performed well during previous crises. Another factor could be the $330 billion of dry powder chasing infrastructure transactions.
We note that private markets valuations tend to lag public markets by up to one year if the public market correction subsists. We have already seen some recovery in public markets with the S&P 500 up 6 percent since the start of the year. The index is now around 15 percent lower than January 2022, so the private markets valuation adjustment, if it comes, will likely be more muted.
It is not all rosy for infrastructure debt: we expect the size of the European debt market to reduce in 2023. Equity investors may delay any non-essential financings and adopt a wait and see approach. Additionally, fund managers will need to be more vigilant around credit quality as higher financing costs affect borrowers’ capacity to service debt.