Bankers love certainty – and infrastructure bankers, naturally used to smooth riding, love it the most. But right now, and for an unknown period into the future, certainty is in short supply.
Across Europe, economic markets are spooked by a surge in energy prices that has stoked inflation and pushed up interest rates even further. Meanwhile, the US dollar has appreciated following hasty rate hikes by the Federal Reserve, while Sterling and euro values have plunged. In the UK, this has led to a surge in gilt yields – and for infrastructure companies, a sharp rise in the cost of borrowing.
For a decade, infrastructure borrowers have been living off low interest rates – and therefore institutional investors seeking an extra return in lower risk assets have targeted infrastructure in their droves.
But all this might be changing with the Bank of England having jacked up rates to 2.25% this month with more steep rises expected in November, after a slow initial response to inflationary pressures. The European Central Bank is planning a 0.75% increase next month and a further hike in December.
Investment-grade corporate credit spreads in euros and sterling have roughly doubled over the last 12 months – and infrastructure debt is heading in the same direction. “It’s clear that the era of ultra-low interest rates is over and borrowers are having to adapt quickly to this new reality,” says EY debt advisory Partner Michael McCartney.
There are other certain consequences of the crisis. The high-yield market is all but dead for now, with spreads in key high yield indices up by over 2% since the start of the year, in addition to those significant increases seen in benchmark rates. “Core-plus infrastructure investors targeting high yield credit is not going to happen,” says one infrastructure debt adviser.
Also clear is that debt service cover ratios are heading south, while leverage of portfolio companies is on the way up. Borrowers, therefore, will not be able to leverage to the same level, making refinancings more challenging. “You can’t get the same amount of leverage in a refinancing that you might have expected even two or three months ago,” says McCartney.
Infrastructure borrowers, meanwhile, with debt maturities in 2024-25 are asking whether they should refinance now with the clear risk that benchmark rates could go up even further. “Do I as an owner need to accelerate my timing on refinancing or do I need to revisit my hedging strategy – or arguably both?” says another sector advisor.
Key short-term sterling swap rates have jumped in recent weeks, but medium- and long-term rates have been less impacted, for now. That may change, though, as markets continue to digest the impact of most recent government announcements and the Bank of England’s intervention in gilt markets.
Meanwhile, the crisis is impinging on infrastructure bidding processes. While investors may still be keen to buy, they are worried about rising discount rates and thus anecdotally are repricing midway through deals. Similarly, rising discount rates on existing portfolios mean investors are likely to have to take what one adviser described as “huge writedowns”.
“These funds have spent the last four years narrowing their discount rates every quarter to make sure their NAVs go up. This is the turning point in which those NAVs go down as the discount rates are adjusted,” the adviser adds. TRIG and INPP’s share prices have dropped just over 12% in the last five days.
Less clear is what will happen to lending volumes. US investment grade public bond issuance volumes are down 12% year-on-year, with European bond markets also down by a similar amount to EUR 180bn during the year to date, according to Bloomberg data.
The general sentiment at present is that while some lenders are holding back, they might only be doing so in the hope of locking even better spreads.
“Investors might pause to see how the next deal prices before they go back in. The benefit from holding back is taking advantage of spread widening and increased yields going forward,” says Tom Sumpster, the head of Private Markets at Phoenix Group.
He adds that special situation strategies are likely to be in vogue “so that investors can benefit for the next 2 to 3 years of likely market dislocation and borrowers' need for immediate liquidity in certain situations”.
Also less clear is the short term future of junior debt. Sumpster says that rising spreads in senior means “mezzanine investors will be seeking higher yields at or above equity returns investments made were originally based on”, adding that borrowers would “far rather restructure their senior debt in a way that protects equity value”. But one junior debt specialist argues the temporary closure of the high-yield market and the higher cost of senior makes junior debt more attractive.
“One thing is increasingly clear, borrowers will need to have multiple options on the table in the event of further market volatility, and some of those will take time to pull together. Starting that work early is unlikely to be detrimental to the cause,” says McCartney.
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