For investors eyeing stable long-term income from a broad and diverse asset class, European infrastructure debt can be a resilient solution. It has been as robust in times of crisis – witness its performance during the pandemic – as it has been across economic cycles. What is its secret? Infrastructure provides services that are in demand whatever the economic climate.
Rates, project costs and returns
We expect growth to lose some momentum in 2023. Europe will likely feel the drag from a contraction in the US. At the same time, the European Central Bank will feel the need to keep policy rates high over time to slow demand and thus contain inflation.
Higher interest rates not only mean higher (infrastructure) project financing costs, but also change the relative attractiveness of investments.
The gap between the dividend yield of eurozone equities (using on the MSCI EUM index) and 10-year German government (Bund) yields has fallen to its lowest since 2010, signalling a revaluation that also applies to fixed income alternatives such as infrastructure debt.
Infrastructure bonds – Solid features
Aside from the economic impact of the war in Ukraine, the attitude of governments and society towards energy security has changed. There is now more support for green energy. Policymakers have prioritised solar and wind power as well as green hydrogen. This focus should boost demand for essential – green – infrastructure. It highlights the solid fundamentals of infrastructure debt.
Infrastructure bonds benefit from longer-term dynamics. Demand for infrastructure services (which include power, water, telecommunications, and transportation), is relatively inflexible, meaning that price increases do not lead to big drops in demand and neither do economic downturns. Arguably, this lack of cyclicality rubs off on infrastructure bonds.
Moreover, infrastructure service pricing is often indexed. Investing in infrastructure can thus be seen as a practical inflation hedge (see Exhibit 1). We also note that infrastructure bonds typically have floating-rate coupons, tracking market developments. This adds to the stable value of the debt. Other features include the monopolistic positions of many service providers and the high barriers to entry for competitors. For example, one motorway between cities typically suffices, giving the toll booth operator a monopoly on that stretch of road.
Attractive investment opportunities
A key area is decarbonisation of infrastructure to help governments meet net-zero emissions targets. This includes car charging platforms, the electrification of rail travel and green mobility.
The demand for power is inevitably increasing, in particular for green electricity. We are seeing more financing transactions in areas such as biogas, distributed energy, energy efficiency and recycling.
Increasing renewables generation as well as distributed solar and green hydrogen involve capital spending on smart grids and upgrading transmission networks.
We are seeing a regular pipeline of opportunities in the healthcare infrastructure sector, boosted by post-pandemic demand and a scarcity of public money. The economy of the future will experience major demographic shifts. Greater rural-urban migration and population aging will drive demand for services such as healthcare or day care, or the deployment of fibre glass networks in rural areas.
Now more than ever, investors are looking beyond returns to the impact of their investments, financing projects that benefit the environment or local communities. Renewables are an obvious target. Challenges include measuring a project’s impact and ever evolving regulations.
Bond issuance has been expanding steadily as new infrastructure is built to keep up with technological progress and existing infrastructure is modernised. This broad and diverse market saw some EUR 310 billion in deal value in 2021 (latest data available); 70% was financed with debt.[1]
Infrastructure debt valuations
Competition and abundant liquidity have put pressure on pricing. There has been some repricing in sectors such as digital technology and energy. A scarcity of materials for greenfield projects or capital for renewables projects may impact business plans. However, an estimated USD 330 billion of dry powder from institutional investors supports the market.[2] We believe this should keep valuations stable.
We have now seen five years of strong fundraising, with 2022 a record year for capital raised for infrastructure. To what degree this continues will depend on the asset allocation plans of investors. During periods of high volatility and market uncertainty, investments often go towards high-quality assets with a defensive profile on one hand and to repriced high-yielding opportunities on the other.
Both are available in European infrastructure debt markets.
You may find investment-grade bonds[3] with a senior ranking at a yield of close to 5%. Other features include low volatility as well as bonds targeting ESG friendly projects. This segment offers diversification from traditional corporate credit.
Investors looking for higher yields can earn absolute returns close to those of core equity from subordinated infrastructure debt.
Market outlook
Within private markets, infrastructure is the second-fastest growing area in terms of retail and institutional assets under management. Data provider Preqin foresees compound annual growth of more than 13% until 2027. The pipeline is particularly full for renewables projects. We’ll likely see more digital (telecom) transactions in view of the need for telecom towers and data centres.
Given the sustained infrastructure investment needs, and demand from asset allocators looking for a stable asset class with attractive yields, we believe the future for infrastructure debt is bright.
[1] Infranews & Inframation, October 2022
[2] Preqin, December 2022
[3] Equivalently rated based on internal ratings
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