Persistently low interest rates, combined with the threat of a rising rate environment in the not-too-distant future, are causing investors to cast a wider net when constructing fixed income portfolios. But that doesn’t have to mean indiscriminately reaching for yield or taking on unwarranted duration risk.
Owing to a combination of factors—including deleveraging, government indebtedness and stricter bank capital rules—there are many areas of fixed income that can allow investors to increase yield while the era of low rates continues and simultaneously position their portfolios for the day when rates do begin to rise.
One of those areas is infrastructure debt, which is debt backed by long-life physical assets that provide a range of essential services to the public. As with other non-core areas of fixed income (such as mezzanine debt or floating rate loans), exposure to infrastructure debt means taking on a new set of risks and giving up a certain amount of liquidity. Due to the long-term nature of most infrastructure projects, and a limited secondary market, investments are intended to be held to maturity.
That said, several factors are contributing to the increasing opportunity to invest in infrastructure debt, and these are largely being driven by the public sector. Much of the developed world is grappling with aging infrastructure and strapped government finances, while many emerging countries are looking to invest in essential services in order to sustain their economic growth. According to Grupo Santander, between 2012 and 2018, some 3,000 projects worldwide will require a total investment of about $3 trillion. Given these figures—and the inability of governments to finance all of the required investments—it seems apparent that there is a funding gap that needs to be filled.
By helping to fill that gap, investors can gain exposure to an asset class that offers steady, predictable cash flows with recurrent income early in the life of the investment. As well, there are opportunities available across the risk spectrum—from mature assets in stable countries that are delivering predictable returns, to earlier-stage projects in developing countries where the future income streams are less certain. And for those investors who are particularly concerned about duration and inflation risk, it’s possible to invest in both floating rate and inflation-linked infrastructure debt, respectively.
Whatever their objectives and risk tolerances, infrastructure debt investors are currently able to obtain higher yields at lower prices than they could prior to the financial crisis. But infrastructure investments also have their own unique risks and costs. For instance, they often require considerable expertise to originate and structure deals, along with the very real need to monitor projects on a continuous basis post-closing.
Infrastructure investors will also look to earn a political risk premium that comes with investing in projects in which national or local governments often have a vested interest. These risks include changes to laws and regulations, as well as political turmoil.
In addition to increasing yield and reducing duration, however, an allocation to infrastructure debt can help to diversify a traditional fixed income portfolio, as these assets tend to exhibit low correlations with core holdings such as Canadian government and corporate bonds. Additional benefits may include the ability to pursue differentiated sources of alpha, as well as the chance to own some relatively low-volatility assets.
While the hurdles to investing successfully in infrastructure debt can’t be ignored, the risk-adjusted rewards for casting a wider net appear compelling. As part of a well-diversified portfolio that meets both investors’ objectives and liquidity requirements, infrastructure may help investors build better outcomes in today’s low-rate world, as well as in the rising-rate environment that will eventually follow.