Schroders Capital: Infrastructure debt remains resilient in the face of macro headwinds

Protected from inflation and benefiting from rate rises, infrastructure debt looks extremely well placed, says Damien Gardes, co-head of infrastructure debt at Schroders Capital.

This article is sponsored by Schroders Capital

How are rising interest rates and inflation impacting the infrastructure debt market?

Damien Gardes

The rate environment has caused investors to adjust their allocations to private assets. While liquid markets gained some attractiveness relative to private markets this year, private debt fundraising demonstrated resilience, with a decline of only 10 percent, much less than in private equity.

On investment activity, investors needed to digest the new environment, with both higher rates to finance acquisitions and higher capex for greenfield projects. The first half of this year was quieter than recent years, but we already see signs of acceleration in deal activity. Given the digitisation of economies and green transition, we remain very optimistic about the infrastructure debt market which naturally plays a leading role in these megatrends.

The market is well protected against the impact of inflation for three reasons. First, assets can generally pass inflation through to end-users and benefit from strong pricing power. Second, operational expenditure that is sensitive to inflation generally represents a much lower proportion of revenues in infrastructure compared to other sectors. And finally, infrastructure companies are typically financed on a long-term basis and therefore, unlike other sectors, infrastructure will benefit, or at worst be untouched, in the face of this inflationary environment.

What do returns look like today versus three years ago, and why is that?

In credit markets the cost of liquidity is a given and the credit margin is governed by demand and supply. We have not observed large movements in supply and demand as there tends to be very little credit migration within infrastructure debt. However, total returns have trended up for infrastructure debt; investment-grade loans paying 2 percent a year ago, and sub-investment grade loans paying 5 percent, are now at around 5.5 percent and 8.5 percent, respectively, benefiting from the impact of rising base rates.

On the whole, investors still stand to benefit from the illiquidity and complexity premium with now higher yields on offer presenting attractive relative value in infrastructure debt from a historical perspective compared to some other pockets of liquid or private credit, especially on a risk-adjusted basis.

What additional credit risks do investors in infra debt face at the moment? What do default rates look like?

The historical loss and default rates for infrastructure debt are comparatively much lower than other debt asset classes; for example, the sub-investment grade infrastructure debt sector exhibits credit losses equivalent to BBB-rated corporate bonds. Therefore, as evidenced by its resilience, we remain totally convinced that the infrastructure sector is well protected and may be the best sector in a high interest rate and high inflation environment, which has become the new norm.

What downside protection does the asset class offer compared with other private debt strategies?

First, infrastructure debt is backed by core and tangible assets providing essential services and that is not generally the case for broader corporate debt or direct lending. Furthermore, credit documentation and structuring is very robust and still bank-style, with discipline having remained around lender protections without the erosion of terms seen in corporate lending.

At Schroders Capital, we are now a large player in the European market, which allows us to have a degree of influence on transaction structuring. If a borrower wants to negotiate, we are able to influence voting rights and secure protective credit terms including appropriate covenants.

How would you describe the relative value of infra debt versus listed infra, liquid corporate credit and infra equity?

We believe that European private mid-market infrastructure debt currently represents the deepest opportunity set, making it possible to achieve much better diversification compared to listed infrastructure debt. Liquid corporate credit is less relevant, given fundamentally different borrower profiles where returns are more driven by market timing.

Maybe the more interesting comparison is therefore to private infrastructure equity, where a massive quantum of money has been raised by GPs over the years. That has supported valuations, with repricing taking some time to work through in the “new norm” creating pressure. It also explains why returns for core assets in infrastructure equity are not necessarily higher than returns achievable in infrastructure debt, most notably for sub-investment grade infrastructure debt, presenting an interesting case for relative value.

Infrastructure equity relies on a mixture of recurring returns and the ability of the GP to realise a gain on exit. That gain depends on an increase in earnings – which relies on the ability of the GP to create added value – and on the exit multiple. Clearly that exit multiple is directly and inversely related to the increase in interest rates, so that is likely to be challenging going forward. 

As such, the ability of the GP to create operating value will be more critical than ever in infra equity, resulting in more variability and volatility in returns across the infra equity market. Infrastructure debt, on the other hand, will remain focused on the preservation of capital by delivering consistent spread return over what are now much higher base rates. 

Finally, what do deal volumes look like right now and how do you expect market dynamics to shift going into 2024?

Our perception is that volumes are already recovering compared to the first half of this year, most notably in M&A activity, which is now showing signs of a comeback. There is also ongoing refinancing activity, pointing to a busy second half of 2023 and 2024. From a deployment perspective, we have been quite active despite the slowdown in the first half of this year.

Further, both energy transition and the digitisation of economies are priorities in Europe that are creating massive financing needs for projects going forward. Private infrastructure debt will undoubtedly play a more than ever critical role in financing those themes, whilst also being central to addressing other macro challenges such as supply-chain disruption and onshoring. Right now, the private credit asset class as a whole is attractive to investors, but infrastructure debt is proving particularly appealing as a flight to quality/safety play for investors seeking resilient and consistent returns.