Infrastructure debt has traded at a spread premium to comparable corporates since the aftermath of the financial crisis and global recession of 2007-09. Much of this is due to banking capacity being withdrawn from the infrastructure market because of banks having less capital available to fund long-dated projects. This, in turn, is due to Basel III, which significantly increased the quantity and quality of capital banks must hold, decreased their leverage limits and increased their minimum liquidity.
Basel III and bank stress tests have resulted in less bank funding for infrastructure
Basel III fundamentally changed the environment in which banks operate by requiring more capital, more liquidity and more stable funding – all sensible measures, but measures that resulted in less bank funding capacity.(1) Common Equity Tier 1 capital (CET1) increased from 2% of risk-weighted assets (RWA) under Basel I and II to 7% under Basel III. Tier 1 capital increased from 4% to 8.5% and total capital increased from 8% to 10.5%.(2) Under Basel II, CET1 used to be referred to as Tier 1 capital or core capital.
There are also two new capital buffers being phased in: a mandatory capital conservation buffer of 2.5% designed to give a cushion during an economic downturn, and a counter-cyclical capital buffer of 0.0-2.5% intended to shield banks during times of excessive credit growth. The level of the counter-cyclical buffer is set by each national banking authority. There are further capital surcharges for systemically important banks and for Pillar 2 risks such as operational risk. In total, banks are likely to target total capital of 13-15%, a significant increase over the pre-crisis days of 8%.
Basel III further introduces a maximum leverage ratio of 3% to prevent an excessive build-up of leverage in the banking sector. This means that a bank’s total RWAs should not be more than 33x its Tier 1 capital.(3) It is meant to be a credible “back-stop” measure to the new risk-based capital requirements described above. There is also a new 30-day Liquidity Coverage Ratio (LCR) designed to cover short-term outflows and other demands for cash. In the LCR test the amount of high quality, liquid assets has to be 100% or more of expected net cash outflows (NCOs) over the forthcoming 30 days.
The effect of the leverage test has been reduced lending, especially in areas outside a bank’s domestic market. This has been observed in a number of jurisdictions where banks are not lending outside their home market. It has also pressured banks to sell low margin assets (e.g., infrastructure). The effect of the LCR test has been for banks to hold significantly more liquid, low yielding assets and fewer illiquid, longer-dated assets (e.g., infrastructure).
Exhibit 1. Infrastructure debt spreads are wider and much more stable than corporate bond spreads
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.
Illiquidity premium over bonds
Infrastructure loans are less liquid than infrastructure bonds. To determine the illiquidity premium, we assessed 235 infrastructure bonds in the European market and compared their spreads to the senior infrastructure loan market. As can be seen in Exhibit 2, the illiquidity premium ranges from 75 bps to 125 bps+.(4)
Exhibit 2. Illiquidity premium: infrastructure loans versus bonds
We feel some of the spread premium of infrastructure is due to a complexity premium as well an illiquidity premium, although this is more difficult to discern from the data. Infrastructure is a creature of contracts and availability and/or demand-based payments. The analysis is unlike traditional credit. Not many investment managers are properly experienced to assess infrastructure risk.
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.
Exhibit 3. The credit quality of infrastructure debt typically improves over time
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%.
Exhibit 4. Infrastructure debt recoveries and loss rates
|Board infrastructure||Corporate bonds|
|Standard deviation (7)||28.1%||39.8%|
|Coefficient of variation (8)||35%||83%|
|Loss rate (bps pa) (9)||10||29/56|
The loss rates for infrastructure can be inferred from the data in Exhibits 3 and 4 and they are very low vs. comparable corporates. Taking (1 – the mean recovery rate) x the default rate or (1 – 0.805) x 0.49% gives a historical loss rate of 9.6 bps per annum (pa) for infrastructure. The same calculation for Baa3 corporates yields (1 – 0.467) x 0.54% or 28.8 bps pa and for Ba1 corporates it is 56 bps pa, materially higher than for infrastructure. We compare infrastructure debt to Ba1 and Baa3 corporates because most infrastructure, although unrated, would be rated Ba1/Baa3 in the first four years after financial close, according to Moody’s. The credit quality then climbs to mid-single-A by year six.
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.