For professional investors only; Infrastructure debt, BREXIT and the search for yield

A sponsor’s position paper by Adrian Jones and Philip Dawes, Allianz Global Investors

Following the cut in August 2015, interest rates have fallen to new record lows, making the search for yield as relevant today as in 2012 when infrastructure debt opened to institutional investors.

Following the cut in August 2015, interest rates have fallen to new record lows, making the search for yield as relevant today as in 2012 when infrastructure debt opened to institutional investors. Pension funds remain short of the long-dated, inflation linked instruments that would best match their liabilities whilst suffering from financial repression with respect to those instruments they can easily buy. Central bank buying programmes of government and corporate securities are, in effect, suppressing spreads by raising secondary market prices and reducing primary market new issuance yields.Senior infrastructure private debt remains a valuable alternative, offering enhanced spreads, which generate positive real returns in a negative real yield environment and diversification benefits. Investors are also beginning to attribute more value to the cash-flow matching benefits of infrastructure debt, (particularly those with amortising structures): Insurance companies benefit from the matching asset adjustments available to insurers under Solvency 2 while maturing pension schemes realise the value of cash-flow as well as balance sheet hedging. But the asset class is not without its challenges. Continued rises in government indebtedness, mean policy-makers continue to be faced with a funding shortfall for long-term infrastructure expenditure while as a result of the trend toward zero or negative rate monetary policy they have fewer tools than ever before to stimulate economic growth. Across the globe political risk and uncertainty is on the rise, characterised in the UK by the recent and ongoing BREXIT debate, leaving investors facing uncertainty. UK government debt now tops £1.5trillion.BREXIT has led some to question whether the European Investment Bank (EIB) will have the appetite to continue to invest in UK infrastructure as we extricate ourselves from our Continental European partners. It does seem that these record levels will not be met in 2016 but the EIB remains active in the UK, most recently with the closure of an £82m financing package for the Humber Gateway offshore transmission project. While the loss of EIB subsidised funding may marginally increase the average margin on projects, given all-in yields are at an all-time low and investor appetite for the sector remains strong, loss of EIB funding, even if it happens, should not be an excuse for reduced infrastructure spending.The new Conservative regime is increasingly looking to favour pro-growth investment rather than continued austerity. HM Treasury has indicated a willingness to work with pension funds and insurance companies to attract investment but the dearth of projects suggest that PF2 has yet to establish itself as the obvious mechanism to facilitate this investment. A seemingly never-ending search for “innovative funding” mechanisms obscures the reality that beyond a few “mega projects” such as the Thames Tideway where genuine novelty was needed to ensure unusual and outsized risks were appropriately apportioned and priced, public-private-partnerships have a long track record in the UK and beyond as a financing model that has delivered hundreds of projects off balance-sheet, on budget and on time. The Autumn statement will give a good indication as to the government’s plans with respect to attracting institutional investment and the form that this may take.Away from the social infrastructure sector, the energy sector continues to offer a tantalising prospect, if only pragmatic reform of the wholesale energy “market” could give the new conventional generation capacity needed to balance the intermittency of renewables (and replace the soon-to-be decommissioned older coal-fired stations) the same certainty of revenue (subject to performance) granted to virtually all other forms of UK generation i.e. wind, solar, new nuclear, probably tidal lagoon, and to a limited extent inter-connectors.The project finance techniques needed to fund new-build CCGT under PPA, CfD, tolling (or similar performance-linked but market-neutral revenue mechanisms) are well established and as the revolution of funding in social infrastructure projects since 2012 has proven, institutional investment working in partnership with shorter-dated bank debt could deliver the dozen or more CCGT plants which are largely permitted and just await funding. One possible result of Brexit may be that UK policy makers may look again at the existing wholesale energy “market” mechanisms in and recognise that fuel supply mix is a largely political question given the eponymous “tri-lemma” of balancing affordability, security of supply and environmental obligations.