- Infrastructure debt can offer a yield premium and diversification benefits
- This is a private market, requiring specialists skills to assess the risks and returns
- As a case study, we look at a UK solar farm portfolio
Infrastructure debt has attracted growing interest from long‐term investors – in particular, insurance companies and defined benefit pension schemes. It offers a yield premium to public credit for investors able to bear the illiquidity of the debt, a premium which is particularly attractive in the current low interest rate environment. And it allows investors to gain exposure to assets that cannot be readily accessed via public markets, bringing diversification benefits.
These long‐dated assets can be a good match for the long‐dated liabilities of insurers and pension funds. Infrastructure projects – such as toll roads, hospitals, schools, and energy infrastructure – are essential to the social or economic well‐being of an economy or society, offering relatively secure income streams. With governments and companies increasingly looking to move financing of these assets off their own balance sheets, and with banks less willing or able to provide long‐term finance, asset managers have a growing role to play in supporting the financing of this much‐needed investment.
For insurers in particular, infrastructure debt can be capital‐efficient within modern solvency regimes, in contrast to other alternative assets – notably private equity and real estate.
Finding, analysing and investing in the asset class requires highly specialist knowledge, creating a significant barrier for most investors. We asked Marianne Froude, Investment Director on our infrastructure debt team, to discuss a recent investment in renewable energy with us.
Q: You financed a solar energy company in 2017. Can you describe how the debt is structured?
A: The company owns six solar farms across the UK. The farms benefit from a UK subsidy scheme which provides a fixed price linked to UK inflation for around half of the energy produced with the other half of their electricity sold on the open market. Given the portion of inflation‐linked revenues, it made sense for the company to reduce the risk of their exposure to inflation by issuing both fixed‐rate and inflation‐linked debt. This is typical of the structure we see in renewable debt financings, where companies seek to hedge their exposure to inflation.
Q: How does this mix of inflation‐linked payments and fixed payments affect debt investors?
A: Investors had the choice of investing in one or both, depending on what suited their liabilities. For many investors, the ability to match inflation‐linked liabilities is attractive as sourcing assets other than government bonds that are expressly inflation‐linked can be challenging.
Q: What were you looking for as investors?
A: We were looking for an asset‐backed, fully amortising structure (where a portion of the loan is paid back each year). This is particularly well suited to the matching‐adjustment portfolios we manage for insurance companies. The time until the loan is due to mature matches the timescale of the government‐backed subsidy, which means exposure to changes in power prices – which have been volatile historically – is reduced. This matching of debt payments with underlying contracted cashflows is typical of major long‐term infrastructure financings.
Q: How do the economics compare to typical corporate bonds?
A: It varies by market and sector. In our example, investors in renewables debt in the UK receive a yield of between 170 and 220 basis points above government bonds. This represents an illiquidity premium of between 20 and 70 basis points relative to a general BBB corporate bond index.
Additionally, recovery rates are significantly higher when things go wrong. Historical studies show that investors in infrastructure debt can expect to recover 70‐80% of their money in a default situation compared with typical rates of 30‐40% for conventional unsecured corporate bonds.
Q: What are the risks?
A: The debt is typically not rated by ratings agencies so we do our own analysis to assess the risk. The primary risk in this deal was energy generation – if the energy generation forecasts are incorrect the company will receive lower revenue which may have an impact on debt repayment. However, we consider the full range of risks. The financing has to be structured to withstand severe downside in all of the risks and this is reflected in our investment‐grade rating. And for those of you wondering why anyone would think of generating solar power in the UK – generation is dependent on daylight, not sunlight!
Q: How active is the secondary market in infrastructure debt?
A: We expect our investors to hold the debt to maturity. Currently there is very limited secondary market liquidity in infrastructure debt. These are private market transactions, negotiated directly with the borrower, and there is a significant degree of complexity involved. However, as the number of institutional investors grows, we expect liquidity to increase.