Junior infrastructure debt for insurance companies
With dry powder for infrastructure equity investment at an all time high, project sponsors have had to become more conscious of financing costs for projects in an attempt to reduce costs to bolster equity returns. With this, we have seen the junior debt segment of the market becoming used more frequently to create more efficient funding structures, presenting opportunities for investors.
Junior debt offers unique characteristics for investors compared to other asset classes:
- Risk/return (on capital) profile – junior debt offers a unique profile where investors can capture a high complexity, or illiquidity, premium for often a better credit profile compared to other asset classes of similar ratings or returns
- Portfolio benefits – traditional high yield corporate bond portfolios are highly exposed to the risk of downgrade risk if a bond suffers a deterioration in credit quality and is downgraded and sold at a loss. Infrastructure debt are private assets and therefore not exposed to this risk unless there is an impairment, which is rare
- Diversification – infrastructure assets are not correlated to the general market and therefore offer diversification benefits not available through other more traditional asset classes
- Tenor – junior infrastructure debt generally has maturities of between 5–10 years, making it well suited for insurers with shorter-term liabilities and for surplus portfolios
- Interest rate protection – infrastructure debt comes in both fixed and floating formats, Schroders invest in about a 50/50 mix, resulting in a low sensitivity to interest rates
With an increasingly competitive infrastructure equity market, project sponsors have had to become more sophisticated in their financing structures to try to reduce debt servicing costs. This has led to more tranching to exploit investors under different regulatory regimes and with different risk/return objectives. Meanwhile regulations have pushed many investors into the investment grade segment of the market, leaving the junior debt part – which is often not investment grade – relatively uncrowded.
Due to the increase in supply of junior debt and less investor demand, we believe the junior debt segment of the market may currently offer a highly attractive risk/return profile, including for many insurers after adjusting for Solvency II capital charges.