As interest rates around the world continue to rise, the attractiveness of fixed income investments has become increasingly compelling, and bonds now offer far more attractive yields than they have in many years.
As the broader economic outlook remains challenging, how do investors take advantage of this to maximize return potential whilst also managing downside risk, especially within higher yielding credit?
We believe that liquid infrastructure credit is an attractive subset of the fixed income market that can be used as core allocation within any fixed income portfolio, or as an alternative to more traditional fixed income allocations such as corporate bonds, high yield bonds and leveraged loans.
This view is supported not only by historical returns produced by infrastructure credit, but also by the favourable long-term themes that support the asset class.
For investors who also want to focus on impactful investments in their portfolios, infrastructure credit provides a large and diverse opportunity set of labelled and unlabelled green and sustainable bonds that provide societal benefits, including combating climate change.
What is liquid infrastructure credit?
Infrastructure assets are typically physical structures or facilities, systems or networks that support the functioning and /or growth of society. Infrastructure debt issuers can include developers, owners, and operators of infrastructure assets across varying industries such as power generation, water and waste management, telecommunication, data transmission, and transportation infrastructure. These industries are often considered defensive and recession resistant. These issuers often have attractive intrinsic characteristics for lenders, such as:
- Issuers tend to provide essential services and often enjoy natural monopolies and high barriers to entry.
- Businesses are often supported by long term customer contracts, and these contracts often benefit from inflation protection that is built into the agreement.
- Issuers generally own tangible “hard” assets which provide strong collateral supporting their debt, and which provide benefits in terms of debt repayment to borrowers.
- More broadly, infrastructure is supported by demographic tailwinds such as urbanization, population growth and economic growth that drive the need for new and updated infrastructure.
Why are they an attractive investment for fixed income investors?
These characteristics have contributed to infrastructure bonds and loans having experienced far lower default rates while also exhibiting superior recover rates (and therefore lower loss in the event of a default) than comparably rated securities, which makes them an attractive sub-set of the sub-investment grade bond market.
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Due to the low historical default rates experienced by infrastructure debt issuers, investors are generally well compensated for the credit risk they incur. This is also evidenced in historical returns of high yield infrastructure bonds, which have been very attractive relative to comparable fixed income indices on both an absolute and risk adjusted basis across market cycles.
This is mainly due to the fact that, the combination of lower default loss and higher yields will generally result in long term outperformance versus lower yielding strategies. In sub-investment grade credit, you would also get the additional expected benefits associated with high yield bonds, which includes diversification (especially with a global strategy), lower volatility compared to equities and lower interest rate sensitivity than investment grade bonds, in general.
Of course, market conditions are always changing and there are times where various parts of the fixed income market are more susceptible to a drawdown or may present better risk adjusted opportunities. It is therefore important to have a strategy that can be flexible across asset classes, credit ratings and duration profiles in order to allow for a larger investable universe and to manage credit and duration risk.
Opportunity for positive impact
The opportunity to invest for positive impact through infrastructure securities is also attractive, especially for those who want to focus their capital on investments that contribute to climate solutions.
The global energy transition, for example, will require significant investment to reduce carbon emissions. This will include renewable energy additions, improvements in energy efficiency, transportation electrification, and new technologies to address climate change.
The investible universe contains a large amount of labelled and unlabelled green and sustainable bonds contribute to climate solutions. In a recent Bloomberg New Energy finance piece titled “New Energy Outlook 2022”, they outlined a baseline assessment of how the energy sector might evolve as a result of cost-based technology changes.
This projects substantial growth in renewable clean energy generation capacity additions through to 2050, which should provide a growing opportunity set in infrastructure assets for impact focused investors.
What is the outlook for infrastructure credit?
In the short term, even if interest rates remain elevated, the ‘pull to par’ for bonds trading below par should provide positive price support for many highly discounted bonds. The defensive nature of infrastructure credit when compared to ‘riskier’ corporate high yield bonds and loans should help to offset downside risk in an environment of slow economic growth, or a recession.
Longer term, infrastructure investments should benefit from a number of megatrends as well as the clear magnitude of the world’s increasing infrastructure needs. These are expected to be a significant and ongoing tailwind for the sector.
