This article is sponsored by Schroders Capital
How can infrastructure debt managers navigate current macroeconomic challenges such as inflation and disrupted supply chains?
I think it’s fair to say infra debt managers have the luxury of being comparatively sanguine in environments that are difficult for other asset classes. Infra debt is not immune, of course. Inflation, supply chain issues, staff shortages and rising interest rates in the real economy will impact companies and projects.
The difference with infrastructure debt is that it is capital intensive and labour light. Earnings (EBITDA) margins are high. Typically, these qualities acting in concert mean that navigating the cycle is easier for infrastructure debt assets than for other asset classes. The underlying assets are more resilient. Inflation can even be a positive.
The key word for managers is selectivity. Different dynamics apply to different types of infrastructure. When you analyse assets during the credit process, the characteristics must line up in the right way. At Schroders Capital, we are focused on core and brownfield infrastructure, with either a senior or junior debt angle.
Going for core means that the underlying assets have regulation or long-term contracts in place. This typically allows them to pass cost increases onto customers if there is inflation in the cost base. Meanwhile, going for brownfield means you don’t have a lot of exposure to the supply chain from construction capex, and there is a lower impact of staff shortages.
Schroders Capital decided a long time ago to focus on the part of the infrastructure spectrum that would work through all phases of the cycle. At some points, it might appear “boring”, but we have stuck to our guns, and can feel the benefit at the moment.
Why does infrastructure debt remain attractive compared to other asset classes?
At this very moment, our view is that debt is more attractive than equity because higher interest rates are immediately reflected in the way we charge for our funds. In the equity space, the cost of capital increasing is not that automatic and equity returns will certainly suffer corrections in the short term.
Similarly, within the wider debt spectrum, infrastructure as an asset class is seen as a safe bet, especially if you invest in the core part. Compared to corporate credit, where a number of segments like high-yield bonds and leveraged finance are almost closed there is far more resilience in infrastructure debt both via the underlying assets and via structural protections.
We invest into secured credit, so we have security over the asset and financial covenants that allow us to control the performance of the company. We can even call for default if necessary. That is usually not the case with high-yield bonds or leveraged finance, and we have found our investors reassured by that.
What different strategies are available within infrastructure debt and where do you currently see the most opportunity?
That’s an important question. Before I delve into the answer, let me offer some context.
Within infrastructure debt you have basically three core segments. There are two in senior investment grade and one in the sub-investment grade space.
The first of these segments is the bank-driven market. This is usually short term, floating-rate and very much driven by banks and their cost of liquidity as they seek to refinance rapidly. The second senior debt segment is the longer-term, fixed-rate investor-driven pocket. This is secure, very resilient, but much more structured for investors because it is a duration product, giving long-term exposure. The final option is the junior or high-yield debt, which is obviously higher yield, shorter-term and a market dominated by debt funds like ourselves.
We consider junior infrastructure debt to be one of the best opportunities today thanks to the benefits it offers at this point of the economic cycle. You get to have a shorter-term debt and a higher yield, which means less exposure to rising interest rates. With higher rates, we have seen junior debt generate returns on a par with an equity investment, making it very attractive from a risk-return perspective. The returns you can get as a junior debt investor today are commensurate with the kinds of returns equity investors were getting six to nine months ago.
How can the asset class respond to the needs of different types of investors?
Senior debt of course continues to offer value depending on what an investor is looking for. It still offers the benefit of a long-term, secure income and, even though interest rates are increasing, senior investment-grade debt is interesting to investors like insurance companies that want to liability match and appreciate that lower cost of capital. There is also an element of ESG play for infrastructure debt versus corporate debt – so there are a number of reasons why it remains attractive to investors.
Junior debt can be relevant for other investors that have higher return expectations as an attractive alternative to high-yield corporate debt.
Our team has been advocating for a selectable market, where investors can basically decide what they want to buy and we can find the best product for them. You can find whatever risk-return profile you want in this asset class.
What do you expect to be the big themes going into 2023?
The outlook is still good. The core macroeconomic environment doesn’t change the intrinsic benefits of the asset class for investors. You still have access to the illiquidity/complexity pick up, the ESG angle, the structural protections and the resilience of the assets compared to corporate assets. On the debt side, we consider the lender community has been reasonable so far, by which we mean leverage on transactions has been sensible. This has allowed us to enter this economic challenge feeling safe.
Of course, we will see how the macroeconomic crisis plays out, but the entry point is reasonable. Given that equity investors have deployed a lot of money and acquired assets at high valuations, that means the gearing is still reasonable and there is a lot of buffer in the capital structure.
In terms of the themes for next year, telecoms will remain a key focus for the team, being in principle telecoms are more immune to economic shocks and with the potential to pass on inflationary pressures to consumers, particularly in the infrastructure layer.
Energy transition is of course another key theme, especially in the current context. If you look at the dry powder available in these areas on the equity side, it is clear that investment is only going to continue to accelerate.
Investors are increasingly tapping into that junior debt piece, the market is more cognisant of the different strategies available and there is more and more segmentation to meet investor demands, all of which are signs of an asset class continuing to mature.