In the first of a two-part series on asset allocation and infrastructure debt, Andrew Jones, Global Head of Infrastructure Debt at AMP Capital, provides a framework for considering private, subordinated infrastructure debt in the context of a diversified portfolio.
Infrastructure debt is increasingly popular with investors, as evidenced by our $6.2 billion fundraise for AMP Capital IDF IV in late 2019. But when considering adding infrastructure debt to their portfolios, many investors are still grappling with where in their portfolio this allocation should sit.
The resilience of this relatively young asset class, which emerged in its current form after the global financial crisis and ensuing regulations such as Basel III as banks reduced their large-scale lending activities and institutional investors stepped in, has just been tested in its first global crisis. We are pleased that the essential nature of the robust businesses we lend to and our carefully-negotiated covenants have meant that no loans in our portfolio have needed to be renegotiated, while some sectors – including digital infrastructure, a focus for us – are performing very strongly.
Delivering for institutions
Infrastructure debt continues to deliver outcomes that institutional investors seek. As we look set to continue in a low-rate environment following the current economic crisis, the consistent yield of infrastructure debt, along with its defensive nature, will continue to be prized.
For insurers in particular, infrastructure debt offers an additional benefit. In terms of regulatory capital treatment, infrastructure debt can qualify for a relatively low capital requirement. Under Solvency II regulation in Europe for example, private subordinated infrastructure debt is treated relatively favourably compared to other private market assets and equivalent corporate credit. In Korea there is a regulatory regime for insurers which has similarities to the European model. Infrastructure debt again has a relatively attractive treatment and thus results in a relatively low capital requirement for investors governed by these rules. This makes the asset class appealing to many Korean insurance companies.
Where does infrastructure debt fit in?
Demand for infrastructure debt funds continue to increase, and as institutional investors build their holdings, they need to think carefully about the outcomes they are looking for from their infrastructure debt allocation, and where the asset class can complement their existing holdings and offer diversification. As a relatively new asset class, infrastructure debt has the potential to fit within many traditional buckets of a portfolio, outlined below.
Real Assets: This bucket invests in tangible investments with intrinsic value due to their physical properties – such as real estate, infrastructure and resources such as commodities, timber and agriculture. This illiquid asset class offers inflation-hedging and a low correlation to equities and bonds. The risk/return profile of the real assets can range widely, and they can be accessed through equity or debt investments.
Infrastructure debt complements these assets as a component of a real assets portfolio, as it is less driven by macro-economic conditions than real estate investments and commodities, which tend to be more cyclical and sensitive to market environment.
Infrastructure: Many investors are now considering infrastructure an essential part of their asset allocation. Within an infrastructure portfolio, which typically is largely infrastructure equity, infrastructure debt can serve a variety of roles. For investors who are seeking the low volatility, high-yielding cashflows of core infrastructure, but who find difficulty deploying capital at attractive return levels in the highly competitive environment for core assets, subordinated infrastructure debt presents an excellent alternative, as annual yields are around 8-10%. For those with exposure to higher-returning infrastructure strategies, subordinated debt can complement and drive cash yield across the portfolio. Value-add infrastructure equity funds will typically target lower cash yields in the first part of the fund’s life as capital is reinvested to drive business growth. Pairing such an investment with a high-yielding infrastructure debt strategy helps ensure the portfolio is cash-generative from the outset.
Adding infrastructure debt to an infrastructure equity allocation can balance the risk profile. Infrastructure debt tends to have lower volatility than infrastructure equity investments and adds even more defensive characteristics to the portfolio. In a stressed market environment, subordinated debt ranks ahead of equity and will be less impacted by market shocks.
Alternatives: Alternatives can be a ‘catch-all’ category that encompasses all assets that are unlisted and illiquid. A typical alternatives allocation can include hedge funds and private equity investments, but also infrastructure and private debt. The role of an alternatives allocation is to provide diversification and deliver attractive absolute returns.
Investors who look to their alternatives allocation for diversification would consider infrastructure debt as a defensive allocation due to its low correlation and low volatility characteristics. It can be grouped with more defensive hedge fund strategies and alternative beta strategies.
On the other hand, investors who are seeking high risk-adjusted returns from their Alternatives allocation may look at private subordinated infrastructure debt for its higher yield and illiquidity and complexity premia.
Fixed Income: The Fixed Income allocation generally includes investments in liquid and public markets such as treasuries, corporate credit (e.g. investment grade or high yield debt) and sovereign credit. The main drivers of a fixed income allocation are the yield and lower volatility of the investment. Investors who consider infrastructure debt as part of their fixed income allocation look to the allocation as a liability match from cashflows; they are not necessarily allocating to the space to generate outsized risk/returns, but rather for stable cash yield. The relative illiquidity of infrastructure debt distinguishes it from the bulk of assets in the bucket.
Private Debt: Private debt, which can include corporate private debt or asset-backed lending strategies, has grown in popularity in recent years. Within corporate private debt strategies, the focus is on cashflows of the borrower to secure the loan, while asset-backed lending strategies are secured by collateral of real estate, infrastructure or other assets such as aircrafts. The structure of private debt strategies, typically closed-end funds, is similar to private equity allocations. Private debt strategies in general may be prone to market cyclicality and performance can differ throughout market cycles: for example, an investor can be more opportunistic with a distressed debt strategy after a severe market downturn to invest at cheaper levels.
Infrastructure debt offers returns comparable to corporate and asset-backed lending strategies, with low correlation. Loans are typically provided to a ring-fenced, bankruptcy-remote entity and secured on a second lien or similar basis against an individual asset or portfolio of assets. The underlying assets are backed by long-term contracted cash flows with investment grade off-takers, or regulator-determined tariffs. This insulates assets from market movements, driving down correlation with cyclical sectors.
Infrastructure debt is a versatile asset class – defensive, diversifying, with a relatively high cash yield – and investors are recognising its value in asset allocation.
Read the paper here: Using infrastructure debt in a diversified portfolio
In our next paper, we will take a closer look at the private debt bucket, and compare infrastructure debt to other subsets of the asset class.
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