To find value in a competitive infrastructure market filled with dry powder, plan sponsors can look beyond equity and senior debt, focusing instead on junior infrastructure debt, according to Claire Smith, alternatives director at Schroders.
“Canadian pension funds are no stranger to infrastructure equity investment, but we’ve seen valuations in this market getting higher,” she said during a session at the 2018 Defined Benefit Investment Forum in Toronto on Dec. 10. The amount of dry powder in infrastructure equity is at an all-time high, she added.
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As well, with markets in their second-longest bull run, Smith said the length of the bull market typically reflects the length of a downturn — in the event of a downturn, equity investors would see the majority of the risk. “So if there is any kind of fluctuations in valuations, fluctuations in the use of the assets, the equity portfolio will be the one who primarily wears that.”
Beyond infrastructure equity, another option is investing in the infrastructure debt market, said Smith. “In the current market dynamic . . . we think that it could be interesting to compliment this infrastructure equity part of your portfolio with some debt.”
She noted the infrastructure debt market has three investible areas — short-and-long investment grade debt and junior debt.
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Banks are still active in the short part of the market and insurance companies are active in the long part of the market, said Smith. Yet the junior debt part of the market is “almost a regulatory arbitrage.” This means investors aren’t facing competition from banks and insurance companies.
While Smith acknowledged senior debt provides more certainty in cash flows and is the lowest risk part of the market, it doesn’t offer a big return. However, plans can see an increase in return for only a moderate increase in risk when moving from senior debt to junior debt.
“It’s part of the market that’s a bit niche,” she said. “It’s growing in terms of supply of this type of debt, and the demand is limited because of the different regulatory regimes.”
While investment managers may define junior debt differently, Smith said she defines it as a fixed income contract with mandatory scheduled interest payments.
Infrastructure includes other benefits, such as a unique credit profile because it’s high quality and not accessible through the corporate bond market; a low-correlation with other asset classes; and a strong return potential, said Smith.
From a risk perspective, an investor is taking on illiquidity risk with junior infrastructure.
Infrastructure debt is an illiquid asset class, so investors are compensated with a much higher return, said Smith. “But when you are searching for yield in such a low interest rate environment, you can either go up the risk spectrum, or you can go out the liquidity spectrum.”
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For pension funds with long-dated liabilities and high illiquidity tolerance this is a very good bet to take, she added.
And from a pension fund perspective, the cash flows may also be attractive. “This can be very important for pension funds because you’ve got very strong contractual cash flows that you can use to meet your pension fund liabilities.”
Read more articles from the 2018 Defined Benefit Investment Forum