30Aug19

SCOR Live Blog

Investments

Infrastructure debt, a source of diversification

As European bond market yields linger in negative territory, asset allocation is becoming increasingly complex.

With the large majority of government bonds already producing negative yields – including the German 30-year bond, yielding -0.12% – non-speculative grade corporate debt is now following suit. Forty percent of bonds with maturities of 3 to 7 years carry negative yields, as do 73% of bonds with maturities of under 3 years.
 
In this environment, the main available options are to downgrade the portfolio’s credit quality in order to maintain its yield or to find other alternative investments that can generate steady returns.
 
Currently, to achieve a yield similar to that of a 10-year corporate bond rated A+ purchased 10 years ago, one would need to invest in an instrument with a rating of BB-/B+. Applying the standard formula under Solvency II for capital requirements, this pushes capital consumption up from 10.5% to 46.7%, while returns stay the same. After a positive ten-year credit cycle, this credit risk increase is all the more problematic now that balance sheet restructuring cases are multiplying, with Thomas Cook and Rallye as recent examples.
 
Although the risk is still idiosyncratic, the possibility of a systemic spread should not be ignored. The European banking sector, which is facing a fall in profitability, could become an ideal conduit if the quality of its assets was to worsen. A credit crunch might then commence and probably cause default rates to rise. This could put a serious crimp in eurozone growth forecasts.
 
In this environment, the diversification of credit risk is now an obligation. The specific characteristics of infrastructure debt financing make it an interesting option for consideration.
 
When financing infrastructure, the debt sizing is based on the generation of highly predictable cash flows, whose use is governed by contractual obligations and guarantees offering a high degree of protection. This type of debt comes with a low refinancing risk and little dependency on the economic cycle.
 
The senior debt segment has looked less attractive due to the long maturity of its debt and relatively lower absolute returns. Up to now, its strong defensive characteristics have only appealed to investors needing to match long-term liabilities (life insurers) and optimize their capital requirements (preferential rules apply to infrastructure debt).
 
Mezzanine infrastructure debt, however, offers many of the same benefits as the senior tranche while also appealing to a wider range of investors, due to shorter maturities and higher returns. Burdened by persistent regulatory constraints and high capital costs, banks cannot effectively meet the needs of certain industrial and financial sponsors. These sponsors sometimes need to produce higher returns or grow their businesses by unlocking capital from a mature asset and reinvesting it in a new asset. This creates a market in which institutional investors can fulfil a pragmatically useful role and thereby benefit from advantageous conditions.
 
For example, it is now possible to acquire junior debt on mature and therefore less risky assets with an average maturity of 5 to 8 years and a yield of over 5%. The Solvency II capital requirement for these securities is only 12%, compared to 58% for bonds rated single B generating the same returns.
 
On the other hand, given the sector’s valuation multiples, infrastructure equity funds provide less and less scope for value creation. Establishing a position in junior debt now offers both recurring returns and genuinely more robust protection than equity infrastructure.
 
In this junior debt space a particular attention should be taken in analyzing the structure of the debt which could be a decisive factor. Unsecured junior debt offers bond-like yields with clearly equity-like risk and no potential to influence shareholder whereas junior amortizing secured debt offer a far better protection. 
 

Fabrice Rossary

Chief Investment Officer, SCOR Investment Partners
 
This article is an opinion article and does not constitute investment advice or recommendations. Neither the author nor SCOR Investment Partners assume any liability, direct or indirect, that may result from the use of information contained in this opinion article.