Infrastructure debt has a superior risk-return profile vs comparable corporate credit. This is due to lower loss rates and higher spreads relative to corporate bonds Winter 2016 / 2017
Winter 2016 / 201723 November 2016
The net effects of Basel III and the US and EU bank stress tests imposed since 2009 have led to a shortage of bank capital available to fund infrastructure. At the same time governments around the world are calling out for more infrastructure spending. The result has been an infrastructure spread premium over comparable corporate credit since 2010, as shown in Exhibit 1. Investors are beginning to step in to take up the slack.
Moody’s global project finance and infrastructure study
Even though infrastructure trades at a spread premium over corporates of similar credit quality, the default, recovery and loss rate data is very favourable for infrastructure.
Moody’s conducts an annual study of project finance loans. It now covers a 32-year period and is a global study covering the developed and the emerging markets. Moody’s most recent March 2016 study covers 5,880 project finance loans. This is their full data set.
As part of the study, Moody’s also has an annual Addendum, the most recent of which is September 2016. This now covers 1,890 broad infrastructure loans, the largest sub-set of the study. Within broad infrastructure, Moody’s breaks down the market into an infrastructure industry sector, which consists of global transportation and social, and a power industry sector, which consists of power transmission and distribution. The 1,890 broad infrastructure loans include 1,730 loans from global transportation and social, and 160 loans from global power transmission and distribution.
Infrastructure default probability drops over time
Several of the main conclusions from the study and the Addendum are listed below and illustrated in Exhibits 3 and 4:
- Average annual default rates 0.49% for infrastructure vs. 0.64% for project finance in general.(5) This is much lower than Ba1 corporates at 1.05% and still lower than Baa3 corporates at 0.54%.(6)
- Credit quality improves over time: by year five infrastructure credit quality is substantially better than that of Baa3 corporates and by year six it is consistent with A rated-corporates.
- Marginal default rates drop after year two due to projects moving from construction to operation and de-leveraging because of amortising loans. Average improvement in credit quality is from high Ba to mid-single-A (i.e., five notches) over six years.
- Unlike corporates, infrastructure recoveries are largely independent of the economic cycle.
The third point encapsulates the most important characteristic of infrastructure debt: that the probability of default decreases over time, unlike investment grade corporates where the probability of default increases over time (see Exhibit 3). This is because strong corporate issuers refinance and there is an ever increasing weak cohort of issuers. We feel this aspect of infrastructure debt is undervalued by the market.
Infrastructure debt has strong recovery rates and low loss rates
According to the same Moody’s study, infrastructure debt has higher recoveries than comparable corporate bonds and much more certainty in recovery levels as shown in Exhibit 4. Even though the mean recovery for broad infrastructure is 80.5%, the mode is 100%. That is, the most frequent recovery is 100%.
Infrastructure is an undervalued asset class relative to its risk
We feel this data supplies solid evidence that infrastructure debt is an undervalued asset class relative to its risk. The analysis shows that infrastructure debt trades at a wider spread premium to comparably rated corporates yet has lower loss rates. Much of this premium is attributable to the lower amount of bank capital available to fund infrastructure and an illiquidity premium. Given that our funds employ a buy-and-hold strategy, the illiquidity premium is a source of alpha and it is something we want to capture for our investors.
Sources on Basel III: Capgemini, “Basel III: A Primer,” June 2014; Accenture, “Basel III Handbook,” 2011; and KPMG “Basel III: Issues and Implications,” 2011.
(1) Basel III was published by the Basel Committee on Banking Supervision (BCBS) in Dec 2010. The Basel III US Final Rule was published in July 2013. Both are being phased in between 2013-2019. The prelude to Basel III was the US Supervisory Capital Assessment Program (SCAP) or bank stress tests carried out by the Federal Reserve in 2009.
(2) These three capital ratios include the new capital conservation buffer of 2.5%.
(3) The US has adopted leverage ratios of 3-6%, with 5% applying to Globally Significant Important Banks (G-SIBs) and 6% to insured subsidiaries of G-SIBs. A G-SIB is a bank holding company with more than $700bn of assets or $10tn of assets under custody.
(4) Blended GBP and EUR infra spreads. Sources: Sequoia, Credit Agricole Bloomberg.
(5) Annualised 10-year cumulative default rates for project finance and broad infrastructure. Moody’s, “Default and Recovery Rates for Project Finance Bank Loans 1983-2014,” March 2016 and 1983-2014 Addendum, September 2016.
(6) Annualised 10-year corporate default rates for 1983-2015. Moody’s, “Corporate Default and Recovery Rates, 1920-2015,” February 2016.
(7) Bond standard deviation Sequoia estimate.
(8) Coefficient of variation (CV) is standard deviation of recovery rate divided by mean recovery rate. It is a measure of the variability of the recovery rate.
(9) Corporate bond loss rates are for Baa3 and Ba1, respectively.