Is infrastructure debt an attractive asset class for institutional investors from a regulatory perspective? To answer this question, we analyzed capital requirements for investors who invest in infrastructure loans and who are subject to different regulations. Dutch pension funds are subject to FTK, European insurance companies are subject to Solvency II, and banks face Basel III regulations.
Written by David van Bragt, Senior Consultant Investment Solutions and Rémi Lamaud, Head of Regulation and ALM at La Banque Postale Asset Management.
We provide insight into the trade-off between required capital and expected return for infrastructure debt. Infrastructure relates to real assets: equipment, facilities and networks providing essential public services. As an investment, infrastructure generates predictable long-term contracted or regulated revenues. The rise of infrastructure debt as an asset class is supported by structural trends like the call by governments on institutional investors to undertake infrastructure projects.
Infrastructure debt also offers an attractive spread compared to investment grade corporate credits. On top of that, this asset class offers diversification benefits within a fixed income strategy, historically low default rates and high recovery rates. Investments in European infrastructure projects, both equity and debt, represented €150 billion in 2017. A breakdown of the various components within infrastructure is provided below. Note the growing share of renewable energy projects.
Figure 1: Infrastructure deal values in Europe (in bn euro). Source: Inframation, 31 December 2017.
The outcome of our research is that investing in infrastructure debt has the following characteristics:
- Infrastructure debt has a lower capital charge compared to corporate credits with a similar rating and duration.
- As an asset class, it is particularly attractive as an alternative for sovereign or credit portfolios if we compare the required capital with the spread level.
- Expected returns are high compared to other typical bank assets.
- Infrastructure debt, however, has a high risk weight, which makes it a capital intensive investment.
- Limited liquidity is a point of attention under Basel III.
- Overall required capital for spread risk increases if infrastructure debt is funded from sovereign bonds or credits. The main reason is that these loans are typically lower-end investment grade (≈ BBB) and have a high duration. All debt investments, however, are senior secured.
- However, we believe infrastructure debt is attractive from a return perspective as expected returns increase when investments in infrastructure debt are funded by sovereigns or credits.
Stricter capital and liquidity requirements currently also make capital intensive and illiquid investments like infrastructure debt less attractive for banks. This creates opportunities for investors who have enough room for illiquid investments on their balance sheets, like pension funds and insurance companies.