The financial crisis tarnished the image of structured debt in the minds of many European investors. Over the past year, however, investors have regained an appetite for one kind of structured debt: infrastructure bonds.
Issuers have been quick to respond, offering $15.8 billion worth of European infrastructure bonds as of mid-December 2013, compared with just $1.3 billion in 2012, according to London–based data provider Dealogic.
“The financial crisis put a halt on anything remotely structured in nature,” says Mike Wilkins, managing director in the infrastructure finance ratings group of Standard & Poor’s Ratings Services in London. But “that general aversion to structured debt seems to have disappeared,” he adds. “The high demand for debt, combined with the high supply of capital, has created an almost perfect storm. European public infrastructure debt issuance in 2014 could be double 2013’s figure.”
The revival of the market is certainly good news for Europe. The surge in public debt in the wake of the crisis impedes government efforts to finance infrastructure. Banks, which also used to fund much of it, are increasingly loath to do so as they trim loan books in response to tougher capital and leverage requirements.
The rise in issuance is also good news for institutional investors seeking assets that provide them with a steady stream of income over many years. Many infrastructure bonds have maturities of 20 to 30 years, making them particularly attractive to pension funds, life insurance companies and sovereign wealth funds with long-term liabilities, says Chris Wrenn, managing director of infrastructure debt at BlackRock in London. BlackRock holds €9.6 billion ($13.05 billion) in global infrastructure bonds and loans.
Investors say that a single-A U.K. pound-denominated infrastructure bond will typically carry a yield of between 1.5 and 3 percentage points more than gilts of the same maturity, whereas a euro-denominated bond will fetch anywhere between 0.5 and 2.5 percentage points over euro interest rate swap rates. Infrastructure bonds rated single-A or triple-B for bonds with 25- to 30-year maturities have a 4 to 5 percentage point yield. As points of comparison, European sovereign bonds have broadly similar yields. Italy, rated BBB by S&P, has a 30-year yield of 4.81 percent as of market close January 6. The European corporate bond market is very thin for 20- to 30-year maturities. The banks have largely withdrawn from it: one reason why public infrastructure bonds are becoming more popular. The European municipal bond market is even smaller. A 19-year bond issued last year by the U.K. city of Leeds, guaranteed by the insurer Assured Guaranty, offered a coupon of 5 percent. Assured Guaranty is rated single-A.
These higher yields are, however, accompanied by higher risks. These include a danger that investors in most other bonds do not have to consider: construction risk, or the possibility that the costs of building will exceed both estimates and the margin for error built into each project. Peter Winning, an asset-backed-securities credit research analyst at London-based Aberdeen Asset Management, says many of his institutional clients are reluctant to take on such risks. “Building projects can bankrupt countries,” he notes.
Perhaps the biggest risk associated with infrastructure debt is the possibility that the project turns out to be infeasible, regardless of cost. “One which has gone very wrong” in Winning’s words, is the Castor Project, a natural gas storage facility off the east coast of Spain. Earthquakes were detected in the area after gas was first injected, prompting the Spanish government to halt injections in September 2013. The project, financed by a consortium of European banks including Spain’s Banco Santander, will not be able to indefinitely fund payments on its €1.4 billion worth of 30-year, 5.8 percent bonds if the storage cannot be used. Work on the Castor Project has been halted pending seismic studies, and some infrastructure bond experts say there is a risk the Castor Project may never be completed.
Some experienced institutional investors also voice concern that the risks inherent in infrastructure bonds are not fully understood by some of the newer investors in the sector.
“When banks lend to these projects, they spend weeks doing due diligence, analyzing cash flow, running models and evaluating the risks of different scenarios,” says BlackRock’s Wrenn. In the case of publicly issued and rated bonds marketed to investors by investment banks, however, “when the road show comes into town, people have just a few days to think about these investments,” he says. “There is a risk that people buy them without the opportunity to understand all the issues.” Wrenn says one solution is to hire a permanent team of specialists. Another is to invest through a third-party experts like his employer, BlackRock — though cynics can counterclaim, of course, that experts are bound to say this.
Some veteran investors think that when it comes to investing in infrastructure debt, the quality of one’s fellow investors is an important consideration — as is largely the case with private equity. For this reason, private debt holds more appeal to them than government debt. Their reasoning is that only experienced investors will have the resources and knowledge to evaluate and then invest in private debt and to attach tough conditions to the covenants under which such debt is lent, such as the capacity for debt holders to take over the assets should payments not be met.
David Cooper, London-based investment director of debt investments at IFM Investors, cites the strict covenants of private debt as one of the main reasons why it makes for a better investment than a public bond. IFM Investors is a A$48 billion ($43.08 billion) asset management firm based in Melbourne and owned by Australian pension funds.
For institutional investors new to European infrastructure debt, veterans offer some rules of thumb. Offshore projects, such as gas storage facilities or wind farms, are considered riskier than land-based projects because of the construction and operational challenges. Projects in which revenue is not linked to traffic volume are at the safe end. One such project cited by investors is the €1.25 billion ($1.7 billion), 25-year bond issued in late 2013 that covers building and operation costs associated with the Granvia consortium, a Slovak public-private partnership to finance highway projects such as the country’s R1 Expressway.
The bond is backed by payments made to Granvia by the Slovak government, rated A by S&P, in return for maintaining the quality of the road. Europe has seen many such road deals before, and its relatively mild climate makes for easy roadway construction and maintenance, so such ventures are hardly earth-shattering. That suits many investors just fine. Considering the troubles of Spain’s Castor, earth-shattering projects hold little appeal these days.