Infrastructure debt: Building back better

Building back better is a term frequently used to underpin efforts to boost the global economic recovery and return society back to normal once the pandemic finally shows signs of being under control. Western governments are spearheading this effort, with their multi-trillion-dollar fiscal stimulus commitments, largely geared towards ‘green’ infrastructure initiatives. These efforts by the public purse to build nations out of the economic doldrums have strong echoes of Franklin D Roosevelt’s New Deal in the 1930s. Even the IMF has reversed its long-held advocacy of fiscal prudence to urge governments not to rush to reduce their liabilities, but remain stimulative.

Amid this spending splurge there will inevitably be opportunities for private capital. But how can the investment community participate?

While many infrastructure initiatives stem from a governmental agenda, they are often formed of lots of smaller projects that are generally funded privately. Such financing includes infrastructure debt, which consists of funding large tangible assets that provide an essential product or service. Such assets can provide long-dated, high-quality cash flow across economic cycles, meaning they are one of the few investment areas that have the potential to deliver stable, low volatility, returns.

This stability partly stems from infrastructure assets often having high barriers to entry. For example, it can take many years and significant funding to build a power plant and gaps in such markets cannot usually be filled at short notice. They also often hold monopolistic positions – most areas only need one supply of a utility service or transportation hub.

Infrastructure projects can also be highly diverse – plans to rebuild the global economy post-pandemic will encompass a wide variety of sectors, such as energy provision, transportation and construction – meaning this asset class can also present attractive defensive qualities.

So how did this so-called ‘safe haven’ asset class respond to the challenges of 2020?

Infrastructure debt did indeed demonstrate its resilience during the pandemic, broadly exhibiting much less volatility than other asset classes including equities. The sector’s relative lack of correlation to the macroeconomic environment proved to be an advantage, as many of its assets offer essential services, which are less likely to experience reduced usage during times of economic stress, in fact remote working ensured that basic utilities and broadband access were in higher demand during 2020.

However, the sector is not homogenous and there were a very clear set of winners and losers during the year, underlining the need to be discerning when considering such investments.

Without diminishing the ongoing human tragedy of the pandemic, there were clear investment winners in 2020, as best exemplified by the stock market gains. Two easily identifiable market drivers in the infrastructure world relate to energy transition and digitisation. These trends existed before the Covid-19 crisis, but were strengthened as a result of the pandemic.

Clearly, renewable energy generation and other industries related to the transition to cleaner/greener sources of energy are vital to achieving a more sustainable economy. Not only do they provide vital services, but many were able to operate without high levels of staff onsite so were able to navigate lockdowns with minimal disruption.

The shift to remote working in 2020 also exemplified why the telecoms sector is now considered an essential service by governments and regulators. The supply of uninterrupted high-speed internet access was critical to the success of lockdown measures. DHL’s 2020 Global Connected Index showed that international internet traffic soared 48% from mid-2019 to mid-2020¹.

On the other hand, some industries were deeply impacted by Covid-19 restrictions. These are areas that had previously exhibited solid fundamentals and, while they continue to experience near-term challenges to their business models, are expected to bounce back once economies fully re-open.

Transportation was significantly impacted by the restrictions on social mobility. Toll roads saw a sharp reduction in traffic, although this was somewhat mitigated by the ongoing flow of heavy vehicles. Encouragingly, toll roads quickly recovered after the first set of lockdowns ended, reflecting the wider public’s preference for using private vehicles as opposed to public transport.

Airports were also hit hard, with international passenger demand for air travel in 2020 falling 76% below 2019 levels². However, in this instance the sector’s recovery to pre-pandemic levels is expected to take several years, reflecting structural changes such as reduced business travel and tourism.

Government spending commitments suggest that infrastructure projects will be commonplace in the future. And it is the sectors such as renewable energy and telecoms that not only held up well during the pandemic, but are also aligned with sustainable goals that are likely to create attractive investment opportunities.

Interestingly, infrastructure’s involvement in energy transition in is not just about renewable energy generation. The phasing-out of conventional energy sources, for example working within the utilities sector, also presents interesting infrastructure financing opportunities. Sectors that combine digital features with green energy and even transportation (such as electronic vehicle charging platforms) are all expected to benefit from a more sustainability-orientated future.

The roll-out of 5G technology, and the replacement of existing equipment, will also be a major infrastructure initiative in the coming years. 5G is expected to be up to 20x faster than 4G and should vastly expand the use of connected devices (or the Internet of Things). This could lead to ‘smart’ cities and accelerate the transition to self-driving cars, as well as improving the overall flow of traffic, improving air quality and reducing the number of accidents.

While these projects are vital to the transition to a more sustainable planet, they will not be funded by government spending alone. A significant amount of private funding will be needed to ensure their successful delivery.

While the scope of privately funded, green-focused infrastructure debt will be vast, monitoring, managing and measuring Environmental, Social, and Governance criteria is not straightforward.

Taking sustainability into account when investing in private companies requires a slightly different approach to the engagement and voting practices of shareholders. By being listed, public companies have a duty to report regularly on all aspects of their business. Whereas access to information is not always accessible in private markets. Moreover, an infrastructure project is generally expected to span several decades and sustainability factors can impact a borrower’s ability to reimburse debt.

Therefore, it is essential for lenders to undertake thorough due diligence on all aspects of a borrower’s business. This can mean measuring the net environmental contribution of a project, considering CO2 emissions and whether a project is aligned with the Paris agreement.

Ultimately, sustainability considerations need to be a core part of any security selection process to ensure unsuitable investments are avoided and that such projects stay true to their ‘green’ label.

Infrastructure debt is one of a diminishing number of assets with the ability to provide long-term, resilient and visible cash flow, underpinned by an attractive yield potential and a clear Environmental, Social, and Governance association. Yet, it is an investment option that may not be suitable for all investors.

To achieve these characteristics, a long-term investment horizon is needed and an ability to absorb less liquidity than other asset classes. Such restrictions mean it is an option best suited to institutional investors, the pension schemes and insurance companies that are able to work to a longer term investment time horizon.

Infrastructure debt’s diversification credentials provide an added attraction to such investors. Not only can the underlying assets be diversified across a wide range of sectors and industries, diversification can also be achieved through the debt capital structure. For example, senior debt can provide attractive valuations thanks to its illiquidity premium and low expected loss; junior debt can offer a higher absolute return while still benefiting from the same resilience of the underlying assets that provide stable cashflow, but with an additional layer of leverage.

Launched in 2017, our infrastructure debt platform focuses on financing a diverse range of tangible assets in sectors including transportation, social infrastructure (universities, schools, hospitals), renewable energy (wind, solar), conventional energy and utilities (heating and gas networks, waste and water treatment) as well as telecommunications infrastructure. An exhaustive Environmental, Social, and Governance approach is a core part of the investment process and benefits from our wider Environmental, Social, and Governance capabilities.

Infrastructure debt will undoubtedly continue to expand as an asset class and attract more institutional investors. New trends and sectors will emerge not only as part of the world’s transition to a more sustainable economy, but also reflecting new digital and technological innovations.

At BNP Paribas Asset Management, we believe this transition will result in a host of exciting opportunities and infrastructure debt will be a key player in the financing of climate-related challenges. Our investigative process seeks to uncover the best of these opportunities for our clients.