Alex Leung
Head of Infrastructure Research & Strategy

Infrastructure debt investors will be able to find more opportunities with attractive risk-adjusted returns in 2024, taking advantage of the still elevated base rates and improving credit fundamentals.

Alex Leung – Head of Infrastructure Research & Strategy

Infrastructure debt fundraising relatively resilient

Private infrastructure had a challenging 2023. After a record fundraising year in 2022, we reported in our Infrastructure Outlook 2024 overall funds raised in 2023 fell by over 50%.

However, across all infrastructure strategies, the environment for infrastructure debt has been relatively positive. Rising rates increased the relative attractiveness of infrastructure debt (especially high yield) compared to core infrastructure equity investments, which has not seen significant changes in returns.

Infrastructure debt fundraising grew slightly in 2023, accounting for almost 20% of all infrastructure funds raised (see Figure 1). This is not surprising, given an Infrastructure Investor survey from the beginning of 2023 already highlighted infrastructure debt as the most in-demand infrastructure strategy. Although there is more demand for riskier infrastructure equity strategies in 2024, infrastructure debt still remains a popular choice for institutional investors.

Figure 1: Infrastructure debt fundraising

Infrastructure debt fundraising
Source: Inframation, January 2024.

This graph illustrates a slight growth of fundraising activity in infrastructure debt in 2023, accounting for almost 20% of all infrastructure funds raised.

Inflation and the higher cost of debt continue to impact transaction volumes (see Figure 2) as borrowers reduce their financing needs. Sponsors can no longer rely on cheap debt to fuel aggressive growth plans and are adjusting their capex to adapt to this new reality, while focusing on optimizing their capital structures across both senior and junior debt. Infrastructure debt transaction volumes were only down 9% in 2023, compared to down 25% for infrastructure equity.

Figure 2: European infrastructure debt (EUR billions)

European infrastructure debt (EUR billions)
Source: Inframation, January 2024

This graph illustrates how Inflation and the higher cost of debt continue to impact transaction volumes as borrowers reduce their financing needs. Infrastructure debt transaction volumes were only down 9% in 2023, compared to down 25% for infrastructure equity.

A positive macro backdrop for infrastructure debt

Looking at the macroeconomic environment, as inflationary pressures continue to subside, central banks will have more room to start cutting interest rates. The US Federal Reserve signaled at the end of 2023 that they are looking to cut rate 3 times in 2024. Although hotter than expected inflation so far this year may have tampered those expectations, the general direction of travel is clear, even if rates stay higher for longer.

In Europe, inflation has actually been coming in lower than expectations compared to 6 months ago. Switzerland surprised the markets by being the first major economy to cut rates in 2024, and other European countries should follow. Consensus estimates expect 10-year bond yields across Europe to begin declining in 2024 (see Figure 3), which should bring some relief to those concerned about potential financial distress.

Figure 3: 10-year government bond yields (%)

10-year government bond yields (%)
Source: Bloomberg, April 2024.

This graph illustrates how consensus estimates expect 10-year bond yields to begin declining in 2024, which should bring some relief to those concerned about potential financial distress.

Infrastructure investors tend to have long term investment horizons, and their investments also have long asset lives, which means it is more important to focus on long term macro trends, rather than fixating on short term volatility.

Forward inflation expectations implied by the swap markets have actually been relatively stable despite the recent uptick (see Figure 4). This is a sign that the long-term interest rate impact on infrastructure assets may be limited despite the near-term volatility.

Figure 4: 5-year forward inflation expectations (%)

5-year forward inflation expectations (%)
Note: Reflects the 5-year average inflation beginning 5 years from now. Source: Bloomberg, April 2024.

This graph illustrates how forward inflation expectations implied by the swap markets have actually been relatively stable despite the recent uptick.

Despite the economic volatility in the past 2 years, infrastructure fundamentals actually remain strong, due to a 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.

The consensus estimates of over 100 listed infrastructure companies as proxy, 2023-2025 revenue estimates have been revised upward by an average of ~15% in the last two years (see Figure 5). The risk of further financial distress and defaults in a stabilizing macroeconomic environment is unlikely since fundamentals have held up.

Looking into 2024, as inflation and interest rates have peaked, we could potentially see a recovery in lending activity, especially for borrowers who have delayed their financing plans, as well as increased financing needs as M&A activity picks up again.

As previously discussed, infrastructure fundamentals remain strong, which means transaction volumes should recover now that risks from this new normal is better understood (akin to the post-COVID 19 recovery).

Figure 5: Listed infrastructure revenue forecasts (indexed, 100 = 2019)

Listed infrastructure revenue forecasts (indexed)
Note: Data based on current and historical consensus estimates of over 100 publicly traded infrastructure companies Sources: GLIO, Bloomberg, UBS Asset Management, September 2023

This graph illustrates how from the consensus estimates of over 100 listed infrastructure companies as proxy, 2023-2025 revenue estimates have been revised upward by an average of ~15% in the last two years.

In our view, infrastructure debt now sits in a sweet spot. The stabilization and gradual decrease in interest rates will incentivize investors to move away from cash and into private markets, while locking in the still relatively high base rates.

The slowdown of redemptions from insurance companies and the subsiding denominator effect due to recovery in equity markets mean there will be more appetite for infrastructure debt from investors in 2024.

Infrastructure debt investors will be able to find more opportunities with attractive risk-adjusted returns in 2024, taking advantage of the still elevated base rates and improving credit fundamentals.

Secular themes for infrastructure debt: decarbonization and the 4Ds

The infrastructure sector continues to benefit from secular tailwinds such as the 4 Ds – decarbonization, digitalization, deglobalization, and demographic change. Infrastructure debt is in a unique position to take advantage of these long-term investment themes.

For example, despite weaker infrastructure debt transactions in 2023, activity remained strong in the energy transition (e.g. renewables) and telecommunication sectors, as investments exposed to secular trends such as decarbonization and digitalization still remain popular (see Figure 6). We will further discuss three of these secular themes below.

Figure 6: European infrastructure debt transactions by sector (EUR billions)

European infrastructure debt transactions by sector  (EUR billions)
Source: Inframation, January 2024

This graph illustrates how despite weaker infrastructure debt transactions in 2023, activity remained strong in the energy transition (e.g. renewables) and telecommunication sectors.

Decarbonization

Arguably one of the most important investment themes across any asset class, the world’s efforts to decarbonize have created one of the largest investment opportunities in a generation.

The International Renewable Energy Agency (IRENA) recently highlighted that the world still faces an annual investment gap of USD 3+ trillion between now and 2050 in order to reach net zero and keeping the global temperature rise to 1.5 °C (see Figure 7).

Figure 7: Recent annual investments and annual investment gap in 2023-50E (1.5°C Scenario)

Recent annual investments and annual investment gap in 2023-50E (1.5°C Scenario)
Source: IRENA, World Energy Transitions Outlook, June 2023

This graph illustrates how the world still faces an annual investment gap of USD 3+ trillion between now and 2050 in order to reach net zero and keeping the global temperature rise to 1.5 °C.

Traditional renewables such as wind and solar will continue to offer the most investment opportunities. However, other green investments opportunities will also grow, including energy efficiency, transportation, biofuels, hydrogen, carbon capture (CCUS).

These opportunities are addressed in the paper Future green investments.

Infrastructure debt investors are particularly well positioned as they can find opportunities that can mitigate some of the downside risks associated with new energy transition technologies and business models.

Digitalization

The COVID-19 pandemic accelerated the adoption of remote work, education and healthcare with the popularization of HD video conferencing. The continued roll out of 5G, AI and internet-of-things (IoT) will increase demand for digital infrastructure.

For infrastructure debt investors, digital infrastructure including towers, fiber and data centers are all attractive investments, given the demand for storage and transmission of data. Debt financing has become an important source to fund the growth of these platforms.

However, one thing to be aware of is that digital infrastructure tends to be more prone to hype (e.g. cryptomining and metaverse a couple years ago; AI now). Sophisticated investors must separate commercial behavior from hype and focus on infrastructure characteristics. This includes high quality counterparties, long-term contracts, access to clean energy, minimal technology risk, and avoiding speculative capex.

Deglobalization

Deglobalization used to carry a negative connotation within the business community, but that is no longer the case. Supply chain disruptions from the pandemic, the Ukraine war, and recently from the attacks on Red Sea shipping, have made onshoring a necessity.

Increased focus on domestic manufacturing capacity and energy security will require significant investments. The EU is also looking to promote “made in Europe” green industries, as a response to the pro-manufacturing policies set out by the US Inflation Reduction Act. Europe is tracking over USD 200 billion of electric vehicle and battery manufacturing investments, and over USD 100 billion of semiconductor investments.

Reshoring accelerates the economic and population growth across previously overlooked areas. Large tech companies simply will not commit billions of dollars to build a new plant, without certainty around energy supply, transportation networks, utility services, and high-speed internet. These tailwinds support infrastructure investments across all sectors.

Pathways to success in 2024 – the fundamentals remain strong

Infrastructure debt fundamentals remain strong in 2024. Risk-adjusted returns are attractive especially as base rates remain elevated while the risk of financial distress declines as the asset class remains resilient.

Infrastructure debt has historically been a lower risk way to gain exposure to the infrastructure, as it offers a premium over corporate bonds while providing good downside protection and lower capital charges (for insurance companies under Solvency II).

Infrastructure debt has low or negative correlations vs. many other asset classes, according to a study by EDHEC, making it a good portfolio diversifier (see Figure 8).

Figure 8: Expected asset class correlations

 

 

Corp. bonds

Corp. bonds

US equities

US equities

Infra  equity

Infra  equity

Private equity

Private equity

Real estate

Real estate

Infra debt

Infra debt

 

Corp. bonds

Corp. bonds

1.00

US equities

 

Infra  equity

 

Private equity

 

Real estate

 

Infra debt

 

 

US equities

Corp. bonds

0.27

US equities

1.00

Infra  equity

 

Private equity

 

Real estate

 

Infra debt

 

 

Infra  equity

Corp. bonds

0.25

US equities

0.20

Infra  equity

1.00

Private equity

 

Real estate

 

Infra debt

 

 

Private equity

Corp. bonds

0.17

US equities

0.78

Infra  equity

0.20

Private equity

1.00

Real estate

 

Infra debt

 

 

Real estate

Corp. bonds

0.08

US equities

0.43

Infra  equity

0.45

Private equity

0.45

Real estate

1.00

Infra debt

 

 

Infra debt

Corp. bonds

-0.10

US equities

-0.35

Infra  equity

0.25

Private equity

-0.35

Real estate

-0.10

Infra debt

1.00

Source: EDHEC, Strategic Asset Allocation with Unlisted Infrastructure; February 2021

This table illustrates how infrastructure debt has low or negative correlations vs. many other asset classes, making it a good portfolio diversifier.

Default rates have also historically been lower for infrastructure debt than for equivalent credit corporate bonds. For example, S&P reported that default rates in 2022 for speculative grade corporate credit was 2%, versus 1% for speculative grade infrastructure.

Credit spreads for European infrastructure debt remains much closer than corporate high yield than corporate investment grade bonds in 2023 (see Figure 9).

With the slight pick-up in corporate bond spreads at the end of 2023, we could also see a potential uptick in infrastructure debt spreads in 2024, since private market spreads tend to lag trends in the public markets by 6-9 months. 2024 would therefore be a good entry point for investors looking to lock in attractive rates before monetary policy gradually loosens.

Figure 9: Spreads on private infrastructure debt (basis points)

Spreads on private infrastructure debt (basis points)
Source: Bloomberg; EDHEC Debt Indices (Europe); Real Estate & Private Markets (REPM), UBS Asset Management, November 2023.

This graph illustrates how credit spreads for European infrastructure debt remains much closer than corporate high yield than corporate investment grade bonds in 2023.

Although the macro environment in 2024 is positive for infrastructure debt, there are still many factors to consider differentiating and create the most value, especially when looking to deliver extra premium versus fixed income or other alternatives. For example:

  • Proprietary origination is important lever to uncover value, as it is difficult to find attractive risk-adjusted returns in private placements or syndicated deals.
  • Mid-market segment continues to be less crowded with ability to secure off-market deals and realize “structuring premium”.
  • Although recent commitments have mainly been concentrated towards a few large manager (flight to quantity), smaller managers can often offer better value proposition thanks to a larger number of transactions in the midmarket space, allowing them to be more selective, as well as a greater focus on bilateral transactions and bespoke structuring.
  • Having a robust but pragmatic ESG framework with measurable KPIs would be an important differentiator in an industry that is increasingly focused on sustainability.

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