“Nature abhors a vacuum.” There is perhaps no sector where this applies more significantly than the financial sector.
As banks became more cautious about lending due to tighter regulations and liquidity requirements following the 2008/2009 financial crisis, private debt (private credit) filled the vacuum.
This included growing investments into assets like infrastructure debt. In 2007, less than $1 billion was raised in infrastructure debt globally. Fast forward to 2020 and almost $25 billion was raised.
Investors searching for attractive risk-adjusted returns, broader diversification, capital preservation, and lower risk have found refuge in infrastructure debt, and governments and businesses have found it a more accessible way to raise funds for infrastructure.
Even though 2023 was a relatively poor year for private infrastructure funding, capital raised in infrastructure debt and the size of infrastructure debt as a percentage of infrastructure funds increased.
Yet, the total transaction volumes of infrastructure debt in Europe fell. But is this fall a minor inconvenience that can be ignored or does it signal that interest in infrastructure debt has somehow peaked?
This article will answer that question. We’ll cover:
- The current state of infrastructure debt
- The appeal of infrastructure debt
- How to invest in infrastructure debt
- Factors behind the positive outlook for infrastructure debt
- Risk factors to consider before investing in infrastructure debt
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The current state of infrastructure debt
As said in the introduction, though private infrastructure funding fell by 50% in 2023, capital raised from infrastructure debt and infrastructure debt as a percentage of total infrastructure funds increased, according to UBS.
Though infrastructure debt showed resilience in these two respects, the same thing cannot be said regarding transaction volumes (deal counts), at least not in Europe, as the chart below shows.
Has anything changed in 2024?
The current state of infrastructure funds as a whole
First, the capital raised through infrastructure financing as a whole grew from H1,2023 to H1, 2024.
Secondly, though transaction volumes of infrastructure financing as a whole continue to decline in H1,2024, “the pace has moderated,” according to CBRE.
Thirdly, institutional investors have been steadily increasing their allocations to infrastructure funds as a whole. Infrastructure fund as a percentage of assets under management rose to 5.65% in H1,2024, up from 5.53% in H1,2023, according to data from Infrastructure Investor.
“All the data continues to point to robust demand for infrastructure among the world’s biggest institutions – with overall assets under management in the sector continuing to grow,” they said.
What about infrastructure debt in particular?
The current state of infrastructure debt
The most important stat is that infrastructure debt as a percentage of infrastructure funds continues to grow.
As of July 1, 2024, it was 25% of total infrastructure funds, according to Macquarie Investment Management. It was just around 20% in 2023, according to the UBS data discussed above.
If infrastructure financing is rising and infrastructure debt as a percentage of total infrastructure funding is rising, the implication is that capital raised through infrastructure debt is also rising.
2. The appeal of infrastructure debt
Since 2007, infrastructure debt has experienced tremendous growth in usage.
While it has filled the vacuum left by more cautious traditional lending, that is not the only reason behind its rapid advance. Institutional investors have been allocating funds to this asset class because it has certain characteristics that they found valuable.
Let’s review some of these below:
Low levels of credit defaults
Historically, infrastructure debt has lower levels of credit defaults (and higher recovery rates) than non-financial corporate debt.
While only an average of 3.9% of infrastructure debt will be in default by year 10, an average of 14.3% of non-financial corporate debt will be in default.
“Default rates have also historically been lower for infrastructure debt than for equivalent credit corporate bonds,” according to UBS.
UBS also notes that the credit spread (a measure of credit risk) on speculative-grade infrastructure debt in Europe is lower than that of high-yield corporate bonds and only a bit higher than that of investment-grade corporate bonds.
Lower ratings volatility
The credit ratings of infrastructure debt are less subject to fluctuations and variability when compared with non-financial corporates.
While the credit ratings of nonfinancial corporate issuers changed by up to 0.6 and 0.4 notches during the 2008/2009 global financial crisis and the COVID-19 pandemic, respectively, that of infrastructure debt hardly moved by only 0.1 notches.
Low or negative correlations with other asset classes
When an asset class has low or negative correlations with other asset classes, it is potentially an excellent choice for portfolio diversification.
Infrastructure debt has this feature, according to 2021 data analysed by EDHEC Infra, a research institute focusing on infrastructure debt and private credit
Infrastructure debt had a negative correlation with corporate bonds, US equities, private equity, and real estate as well as a low correlation with infrastructure equity.
Certainty of cash flows
Most infrastructure debts are structured with concession agreements and other regulatory frameworks guaranteeing cash flows over a defined period.
“The regulatory framework or concessions that infrastructure services are provided under tend to last for more than 30 years, with pricing provisions aimed at generating a predictable return over time,” according to Brookfield, a global investment firm.
Returns exceed other fixed-income financial instruments
Infrastructure bonds outperformed global bonds and US bonds between 2013 and 2023 according to data analysed by Macquarie Asset Management, a financial services firm.
They also compared infrastructure high-yield bonds with global high-yield bonds and found the same thing: the former outperformed the latter.
(Note: This does not constitute investment advice as past performance does not guarantee future performance.)
Low pricing volatility
Some infrastructure projects enjoy a natural monopoly that gives them pricing power.
Also, many of these infrastructures are essential services, which means that demand is inelastic – higher prices do not reduce the quantity demanded.
Even when natural monopoly is absent, we have seen that some of these projects have regulatory frameworks and concession agreements that guarantee predictable returns.
Inflation protection
Most infrastructure debts are structured to provide inflation-adjusted cash flows and guarantee a real rate of return.
“In some cases, revenue increases due to inflation are embedded in concession agreements, licenses and contracts,” according to Brookfield. “In other instances, due to the essential nature and inelastic demand of infrastructure assets, owners can pass inflation on to consumers through price increases.”
High entry barriers
High entry barriers imply very low competition which means pricing power and a higher return on investment.
The entry barriers to infrastructure provision include high capital costs, geographic location advantages, and contractual and/or regulatory frameworks, according to Brookfield.
All of these factors mean that infrastructure debt has very low risk and yet offers higher returns than asset classes with similar risk profiles – bonds. In essence, it can provide very high risk-adjusted returns while also offering diversification benefits.
For some investors, the opportunity to contribute to the economic growth and development of different nations across the globe is an extra motivating factor.
3. How to best invest in infrastructure debt
Retail and institutional investors can purchase infrastructure bonds directly or they can invest in them through infrastructure debt funds.
Infrastructure debt funds are mutual funds that pool funds from various retail and institutional investors to invest in infrastructure debt across the globe.
Some of the most popular infrastructure debt funds include:
- Allianz Global Investors Infrastructure Debt
- AMP Capital Infrastructure Debt
- BlackRock Infrastructure Debt
- Macquarie Infrastructure Debt
- Westbourne Capital Infrastructure Debt
- Global Infrastructure Partners Infrastructure Debt Fund
- IFM Investors Infrastructure Debt
- HSBC Global Asset Management Infrastructure Debt Fund
- Rivage Investment SAS Infrastructure Debt Fund
Though there are already infrastructure ETFs, ETF issuers do not seem to have caught up with infrastructure debt just yet.
4. Factors behind the positive outlook for infrastructure debt
We have seen why investors love infrastructure debt. But there is a question more relevant for our purposes: should asset owners allocate more funds to infrastructure debt?
There are two ways to answer this question. We will consider short-to-medium-term and then long-term factors that should make infrastructure debt attractive to asset owners.
Short-to-medium-term factors that make infrastructure debt attractive
Interest rate cuts
Lower rates increase liquidity in private markets. In our context, it will encourage infrastructure providers (borrowers) to complete pending projects and start new ones. This will lead to a greater demand for infrastructure debt financing and more opportunities for investors to allocate funds to this asset class.
Swiss National Bank, European Central Bank, and the Federal Reserve have already cut rates this year. More importantly, analysts expect even more rate cuts by the Federal Reserve, according to Reuters.
Inflation expectations
Though inflation in the US has been above the 2% target since 2021, the Kansas City Fed has shown that longer-term inflation expectations remain anchored.
UBS also reviewed 5-year forward inflation expectations in the US, United Kingdom, and Europe and concluded that rates have been stable.
The fact that inflation expectations are anchored and stable means that it is very unlikely that inflation will get out of hand necessitating a new set of interest rate hikes.
As we have seen, interest rate hikes can discourage infrastructure providers from completing projects or starting new ones.
Strong fundamentals
In early 2024, UBS noted that despite economic volatility, the fundamentals of infrastructure debt remained strong: “robust post-pandemic recovery, strong inflation passthrough, policy support, and the fact that most infrastructure investments are unique assets that provide essential services and have pricing power.”
They also mentioned how this has resulted in the upward review of consensus estimates of the revenue of 100 listed infrastructure companies by an average of 15% in the past two years.
These strong fundamentals are the reason why CBRE expects that listed infrastructure will exceed their average returns (8-10%) in 2024 and 2025.
Long-term factors that make infrastructure debt attractive
There are three such factors, according to Brookfield: digitalization, decarbonization, and deglobalization. They believe that these factors will spur a $200+ trillion investment over the next 30 years.
Digitalization
There are three important pointers here, according to Brookfield.
First, the desire for faster speeds, greater bandwidth, and lower latency means we have to upgrade our networks from copper to fibre. Second, additional infrastructure like new cell towers will be needed to support the spread of 5G and other wireless solutions. Third, the growth of AI and cloud-based services will require that we increase our power and digital capacity.
One example of the infrastructure needed is data centres. They pointed to a McKinsey and Co. report that forecasted that data centre power consumption will increase by sixfold between 2016 and 2030.
This means that not only do we need more data centers but we also need renewable energy to power them safely and cost-effectively.
Furthermore, Macquarie Asset Management pointed to AI, driverless cars, IoT, and robotics as the technologies that will further increase the demand for data and thus drive the need for “robust, reliable, and low-latency digital infrastructure.”
Decarbonization
The need to mitigate global warming and promote sustainability has made decarbonization a global discussion. Governments across the globe are emphasising the need for renewable energy sources like solar, wind, and hydroelectric power.
Brookfield noted that we need global investment in clean energy and energy transition to reach $4.5 trillion per year by the early 30s for net-zero emissions by 2050 to become a reality.
The combination of government incentives and strong corporate demand has made investment in decarbonization desirable if infrastructure providers can procure the needed capital.
One important point made by Brookfield is that current power grids cannot handle the buildout of renewable power we need to reach net zero emissions. This implies that massive investments in grid upgrades and extensions will be needed going forward.
Deglobalization and energy security
The global supply chain disruption caused by the pandemic reminded policymakers of the limits of globalization. Responses to this awareness have included nearshoring and reshoring of the manufacturing processes of essential items (including energy).
Efforts to increase local manufacturing capacity will require massive investment in local infrastructure, providing more opportunities for infrastructure providers to thrive.
UBS also highlights the importance of demographic change as the fourth secular theme for infrastructure debt.
Macquarie Asset Management summarises this point well: “Demographic shifts, including urbanisation and ageing populations, have underscored the need for substantial investments in urban infrastructure, healthcare facilities, and retirement homes.”
Advanced economies with high migration rates will also have to invest in expanding their infrastructure to curtail infrastructure decay and promote sustainable growth.
The need for growing urban infrastructure will also enhance demand for infrastructure debt, providing more investment opportunities.
“Projects like urban transit systems to accommodate growing urban populations or the expansion of healthcare facilities in regions with ageing demographics are typically financed through infrastructure debt,” according to Macquarie Asset Management.
In sum, the volume of infrastructure needed in the long term will require government entities and corporations to look outside of the public markets and raise more money through private debt.
5. Risk factors to consider before investing in infrastructure debt
Everything has sounded very rosy so far. Perhaps you are ready to include infrastructure debt as part of your investment strategy.
Before you do that, take some time to consider some risk factors associated with infrastructure debt. While these factors do not imply that you should avoid the asset class, they propel you to do the necessary due diligence and research.
So, what are these factors?
Jurisdiction-specific risks
These are risks that are peculiar to certain jurisdictions.
They can include the absence or weak application of the rule of law, political instability, and lack of economic transparency, among others.
The absence or weak application of the rule of law implies that contractual agreements cannot be fully relied upon because you might find it difficult to defend your rights in the courts.
Political instability caused by civil or multinational wars can lead to the destruction of valuable infrastructure (like other real assets) and increase the possibility of credit defaults.
Finally, the lack of economic transparency can result in capital controls, making repatriation of cash flow difficult.
Interest rate risks
As we have seen, interest rate changes can affect the completion of existing infrastructure projects and the number of new starts.
Currency and repatriation risks
If you invest in infrastructure projects in other countries, then there is the risk that local currency depreciation will reduce your rate of return.
This is especially concerning if you invest in emerging markets.
Moreover, a country hell-bent on defending its currency may implement capital control policies to prevent withdrawals of hard currencies (since such withdrawals can further weaken its currency).
Long-term viability
Though we can forecast infrastructural needs based on current technology and projected technological developments, the creative destruction process always has surprises in store.
Rapid technological developments can make an infrastructure outdated and in need of replacement faster than expected, thus increasing the risk of credit defaults.
ESG concerns
If you are passionate about ESG issues, then you need to be sure that the whole infrastructure construction process adheres to those standards.
Not all infrastructure providers prioritise or even care about such issues, so there is a need to do some due diligence to ensure you are not funding projects that don’t align with your values.
Regulatory complexity
Infrastructure projects are often subject to complex regulatory frameworks. As an investor, you must navigate these regulatory dynamics to understand how the project will generate cash flows for you in the future.
However, regulations can be very complex and regulatory regimes can change.
If you are directly investing in these projects, you need to consider how these five risk factors apply and design risk management strategies that will protect your investment.
On the other hand, if you are investing in infrastructure funds, you need to speak to fund managers to understand their investment process, especially the risk management strategies they implement.
If you are interested in infrastructure debt, it will be beneficial to share your investment ideas with other investment professionals who have experience in this asset class and in the country where the project is domiciled.
At cio investment club, we aim to improve your investment decisions by providing you with a community of professional investors and investment experts that you can interact with on various investment topics, including infrastructure debt investments.
We provide this interaction through our exclusive roundtables and investment breakfasts that bring together asset owners and asset managers from across the globe.
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Takeaways
- Though investment in infrastructure funds as a whole slowed in 2023, infrastructure debt proved resilient.
- Lower credit defaults, the certainty of cash flows, low or negative correlations, inflation-protected cash flows, and low price volatility are some of the factors behind investors’ interest in infrastructure debt.
- In the short-to-medium term, interest rate cuts, anchored inflation expectations, and stable fundamentals make infrastructure debt attractive.
- In the long term, decarbonization, digitalization, deglobalization, and demographic change offer a positive outlook for infrastructure debt.
- Infrastructure debt risk factors include jurisdiction-specific risk, interest rate risk, currency risk, long-term viability, and regulatory complexity.
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