Managing your four toughest infrastructure debt risks

At the same time, they look to improve their funding position by allocating to a range of higher-returning assets.

Investments are therefore classified as either matching or growth, with fixed and index-linked bond allocations typically used for matching purposes.

Low yields, however, have triggered an increasing interest in alternative matching assets.

These include bonds derived from infrastructure, long-lease property, renewable energy, mining royalties and leveraged loans.

The challenge is that these assets no longer fit the traditional framework, as they contribute to both liability hedging, in the form of cash flows with direct or indirect inflation linkage, and growth, in terms of the illiquidity and credit premia they contain.

Infrastructure debt, which is currently one of the more attractive assets in this category, offers a case in point. The inherent stability of the underlying projects means infrastructure debt can produce predictable, long-term cash flows in a format well suited to pension schemes – be it on a fixed, floating or index-linked basis.

Furthermore, following the withdrawal of bank lenders who had previously underpriced the asset class, this type of debt is now offering returns – approximately a 200-250 basis point spread over gilts – that are attractive to institutional investors on a risk-adjusted basis.

However, this dual nature also entails additional risks that must be understood and managed. Aside from the risks usually associated with non-gilt bond investment, such as counterparty exposure and currency risk, infrastructure debt also introduces new risks, including illiquidity and the potential for prepayments.

Managing your infra debt risks

Credit or counterparty risk needs to be managed by introducing some diversification into the portfolio.

In broad terms, infrastructure assets are fairly uncorrelated and contain idiosyncratic risks that require analysis as part of the due diligence specific to each transaction. An ability to consider these risks and ensure appropriate diversification is therefore essential.

Illiquidity risk can be mitigated through various strategies such as investing alongside other lenders or investors and using formal credit ratings. Importantly, these ratings should include internal as well as external assessments. 

Other strategies involve determining a minimum-size transaction, favouring certain debt formats over others and selecting by industry and credit profile.

Prepayment risk is a feature of many infrastructure debt assets, particularly those in bank loan format. This is because banks have traditionally sought to recycle assets by encouraging borrowers to refinance debt regularly. It is therefore essential any investor appreciates the likelihood of a prepayment through a detailed review of both the associated documentation and the strategy of the issuer.

Infrastructure debt is a highly diverse asset class, meaning pension schemes are able to tailor portfolios to meet their bespoke investment and risk requirements. For this reason, most investors to date have opted for segregated mandates designed to complement the rest of their liability-matching assets.

Typical guidelines and restrictions for these mandates cover overall size, currency, diversification or a single risk limit, and the debt format – for example, whether it is a loan, private or public bond.

They also include the maturity, credit profile, construction-risk exposure, sector selection, credit rating requirements and overall term of the investment.

An allocation to infrastructure debt provides pension schemes with the potential for enhancing both liability-matching and expected returns at a time when yields elsewhere are unattractive.

The key is to control the additional risks through careful management and mandate design.

Chris Wrenn is co-head of infrastructure debt at asset manager BlackRock