Resilience, renewables and rates

Read this article to understand:

• Why the infra debt market has yet to experience the spread widening seen in public bond markets
• Why it has become more challenging to meet the twin objectives of net-zero alignment and a decent return
• Why 2023 could see a healthy adjustment in transaction pricing

Inflation surging to levels not seen in decades. Central banks aggressively hiking rates to counter the inflation threat. The Russian invasion of Ukraine, which highlighted the fragility of energy security in Europe. Three UK prime ministers in a matter of weeks. Equity and public bond markets falling in unison. Yes, 2022 was quite the year.

Amidst the turbulence, the infrastructure finance market held up well. In the year to the end of September, €248 billion of infrastructure bond deals were completed in the euro region, according to Credit Agricole, down 29 per cent on the same period in 2021.¹ Investor demand for those transactions remained high, however, with an average oversubscription ratio of 3.3 times (versus three times in 2021), perhaps helped by an average new issue premium of 14 basis points, compared to four basis points in 2021.

And while rising rates and volatility dampened activity in the second half, the market did not see the same degree of credit spread widening as public bond markets.

This is partly down to a lag between private and public markets in their reaction to external factors; but perhaps it also reflects the historical resilience of infrastructure debt versus public comparators. Between 1981 and 2021, the S&P Global Ratings five-year average cumulative default rate for infrastructure was 1.84 per cent, compared to 7.86 per cent for non-financial corporates.²

To reflect on 2022 and understand what 2023 might have in store for the asset class, we talked to Sinéad Walshe (SW), director, infrastructure debt, Aviva Investors, and Florent del Picchia (FDP), head of European infrastructure debt, Aviva Investors.

How would you sum up 2022 for infrastructure debt?

SW: Whilst it was a turbulent year with unexpected issues hitting us from different directions, it is testament to the resilience of infrastructure that it performed so well. A lot of assets have inflation linkage in their structure, so lend themselves well to an inflationary environment. They have not been as adversely impacted as public markets, which tend to react quicker in terms of spread widening.

That lag is still playing out. At the same time, our clients are institutional investors who can look past the short-term volatility and take a longer-term view. They want longer duration, medium-to-long-term investments for the next five-to-ten-to-fifteen-plus years, and infrastructure debt can help deliver that.

The overall level of deal flow and activity has been good. That was particularly true in the first half of the year, where there was pent-up flow from 2021.

We deployed around £1.3 billion of capital for our clients in 2022. If someone had said that’s where we would get to in February after Russia invaded Ukraine, we’d have taken that result.

FDP: As Sinéad highlighted, the resilience of infrastructure debt has come to the fore. Of all debt asset classes, it’s the one that has looked the strongest during this period. Investors are naturally more risk averse in challenging times and infra debt is benefiting from that.

Euro flow has been exceptionally strong in the circumstances, particularly relative to sterling. This is due to the larger size of the euro zone economy and the diversity of countries constituting it, allowing for a stable deal flow, but political stability may also have been a factor in the second half of the year.

If rising inflation and rates dominated markets in 2022, what will be the dominant themes of 2023?

FDP: Inflation will still be a factor, but infrastructure is well protected against that, which we believe will support investor appetite.

The bigger issue is the extent to which base rates increase. So far, we haven’t seen a major impact on infrastructure debt – whether that’s in terms of it being a credit risk issue due to higher borrowing and servicing costs, or in terms of reducing transaction volumes.

If higher rates persist, we can expect more of an impact – particularly on new deals and refinancings. But I would expect that to be relatively limited – infrastructure is an essential part of the economy. Assets still need to be built and operated, which require financing.

SW: The caveat is around the type of asset and to what extent demand is driven by economic conditions. During the pandemic, transport assets were hit the hardest – particularly airports as international travel was heavily restricted by governments. Now while we’ve seen that sector recover in 2022, any kind of recession will likely cause that type of activity to slow down.

Infrastructure has proven its resilience over the long term; but it’s generally slower to readjust to conditions than other sectors. If you take real estate for example, we’re already seeing valuations adjust to economic conditions and interest rates. That hasn’t happened in infrastructure yet, but there will be questions over whether current leverage levels make sense on some deals in a higher-rate environment. For now, it’s encouraging that we continued to see M&A activity up to the end of 2022.

How about the relative value of infrastructure versus public bond markets?

FDP: It’s difficult to give a definitive answer at this point given how infra lags the public markets. If we go on past crises, what happened during the pandemic might offer some insight. At the time of the first lockdowns, spreads on public corporate debt rose quickly and significantly – to levels higher than we’re seeing now.

However, and this is where comparisons can be misleading, they also came down very quickly – within a few weeks – as monetary policy was still loose and governments stepped in with fiscal policy support. By comparison, we also saw some spread widening in the infrastructure market, but it was much, much smaller – around 20 basis points rather than 150-200 basis points in the case of public markets. But the spread widening in infrastructure happened progressively, well after the peak had passed on the public side.

Over the past year, we’ve seen a much more progressive widening in corporate bond spreads in response to rising rates and the geopolitical and macroeconomic environment. Infrastructure debt has also seen gradual increases, but so far by lower margins. So, we are in a situation where the illiquidity premium over public debt has narrowed considerably and may even have gone negative in some cases for sub-investment-grade (IG) transactions.

However, with the high-yield public markets strongly impacted for most of the year and expectations of rising downgrades and defaults on the public side, in particular in the BBB- and sub-IG space, a simple spread comparison may not be significant as relevant, as this will not account for the higher resilience of the infra debt asset class.

As for what happens now, banks’ increased cost of funding should over time translate into higher spreads in infra debt, including on the institutional side. As to when this will materialise and whether they will widen to a point where the previous illiquidity premium is restored, that’s difficult to say at this stage.

SW: I’d add a couple of points. Firstly, what happens in the bank market tends to drive pricing in the institutional market. And because of wider sponsor relationships in the bank market, any pricing adjustments tend to be more muted and slower – there’s less of a knee-jerk reaction to market conditions.

Second, price movements tend to be more pronounced in sterling because there is a smaller pool of banks with large deposit bases than is the case in Europe. So the increased cost of funds will impact wider bank pricing on infrastructure loans more acutely. However, we’ve reached a point in Europe where banks are having to pass some of the costs back to the sponsors, which is somewhat reflected in increased pricing in the infra market.

I think that rebalancing of pricing will become a big theme for 2023, which is a healthy development. With rates increasing, investors’ expectations of acceptable levels of return should also increase on new transactions.

Where do you see opportunities emerging?

SW: One trend we see a lot more of is investment in infrastructure platforms. It's competitive on the equity and debt side. Infrastructure sponsors want to invest in something they can grow and develop. These platforms also allow a more sophisticated approach to their capital structure in terms of putting debt at the operating company level and at the midco level, appealing to different sources of liquidity with different risk-return appetites.

What we will hopefully see in 2023 is leverage being appropriate to the rating sponsors are trying to deliver, with more value and illiquidity premium on offer at each point along the risk curve.

FDP: At a sector level, some will remain extremely competitive, like renewables. That’s positive in terms of supporting net-zero goals, but the flip side is how aggressive some transactions have been in terms of pricing and structure.

SW: Demand for renewables continues to be exceptionally strong. We assess projects objectively from a rating perspective, but there can be a disconnect between our ratings of renewable projects and what they are yielding. Given many of our clients have a net-zero target, trying to meet both that and their return target is becoming more difficult.

Understandably, they want both. It’s possible there will be certain jurisdictions where you can find a premium, because of the linkages to the sovereign rating, but you need to be mindful of concentration risk.

What are your expectations for transaction activity in 2023?

FDP: I don't see a big difference; there might be a slight fall but there will be sufficient opportunities for us to deliver on our mandates across geographies and sectors. We’ll continue to see strong activity across most sectors. 

SW: I agree with Florent and expect healthy activity across a broad base of sectors with continued strong flow in renewables supported by strong debt and equity liquidity.  We are also seeing increasing appetite for merchant-based structures within the renewables market.

Another area to watch is how sponsors react to the increased cost of borrowing and the consequent impact on M&A flow and the volume of refinancings. It will serve borrowers well to have access to multiple sources of liquidity to protect against further volatility.