From crisis to sustainability: five key issues for infrastructure debt investors

There is no doubt that 2022 is proving to be a challenging year both politically and economically. What was unimaginable for most of us just a few months ago - the attack on Ukraine- is now a sad reality, and the extent and consequences cannot yet be assessed.

As we all try to navigate this uncertain new reality, governments seek to support booming demand for digital services as well as a "greener" economy, infrastructure spending will increase from 2022 and beyond. This should open new opportunities for institutional investors looking for stable, long-term cash flows in a low interest rate environment. Claus Fintzen , CIO and Head of Infrastructure Debt at Allianz Global Investors, which has more than €20 billion of debt invested in infrastructure, discusses the key issues to watch out for in 2022.

Rising interest rates pressuring borrowers down the road

It is difficult to foresee exactly what the macroeconomic impact of the Ukraine invasion will be. But it is certainly a realistic assumption that we will have to expect higher energy and raw material costs in the future. The resulting inflation should then lead to higher interest rates.

When financing a company or project, investors need to consider what the terms might be in the future when repayment is due. We are still in a low interest rate environment. Issuers are taking advantage of this and have increased leverage accordingly while interest rates remain the same.

Higher interest rates could pose a hurdle for many companies - including those in the infrastructure sector - that need to refinance their debt in an environment of much higher interest rates. Will they then be able to service their debt while maintaining their investment grade status?

At the same time, even though rates are on the rise, we’re still in a low-yield environment. Under these conditions, infrastructure debt can still provide significant benefits to investors with a buy-and-hold mentality. Infrastructure projects are inherently long-term illiquid sustainable assets, and their illiquidity premium may provide superior yields to many sovereign or covered bonds.

Infrastructure projects hurt by Covid-19 should recover – but slowly

The impact of the pandemic on the world's population is still being felt - and may never be fully quantified. But one of the factors we can measure is how hard it hit the transportation infrastructure, as passenger traffic came to a virtual standstill when the pandemic broke out. Many airports, toll roads and other "essential assets" did not have sufficient ongoing cash flow to continue servicing their loans.

In some cases, shareholders have been asked to step in, while other companies have had to negotiate with their banks to extend the liquidity line or draw on existing credit lines to bridge this period. Therefore, the liquidity position of these assets is a key factor. Consider these different sectors:

• Airports: passenger numbers are likely to recover to pre-pandemic levels, but it may be some time before that happens. Investors should be able to figure out how airports plan to meet their capital needs in the meantime.
• Road traffic: traffic volumes fell by 90% during the lockdowns. After the restrictions were lifted, however, traffic quickly returned to pre-pandemic levels.
• Public transport: this sector has suffered, but has shown great resilience, thanks to the support and financial backing of municipalities. These important services will continue in some shape or form as people return to normal life after the pandemic.

After Covid-19, many infrastructure forms are expected to recover gradually, but some will need more time - especially airports with a high share of intercontinental traffic. We expect the impact on airports to continue for three years before possibly returning to 2019 levels.?

Transformation to a sustainable footing

Many investors are interested in green bonds and renewable energy investments to drive the path to a carbon-neutral economy. This also reflects the increasingly widespread pressure to take ESG (environmental, social and governance) considerations into account in investment decisions. The current political situation also underpins the drive to significantly increase the share of renewable energy.

One growing area is green bonds, which support specific climate-related projects and renewable energy. Some green bonds are being swamped by demand. As a result, financing terms have softened so that some can no longer be considered investment grade. This may mean that in some transactions where there is strong investor demand, lenders receive less protection. Therefore, investors should be very selective in choosing their transactions.

Over the years, the industry has made significant progress in its understanding of ESG. However, investing in ESG "friendly" assets only leads to net zero up to a point. For example, a company may issue a green bond to support a specific sustainable project. But that doesn't necessarily mean the entire company is on the path to carbon neutrality. Sustainability-minded investors should favour investments that support a holistic transformation of the company and should seek to support other issuers on their "green" journey. We see particular opportunities in the area of new energy technologies - such as batteries, hydrogen and biofuels - as companies can invest in new areas and thus reduce their CO2 emissions. Such investments are usually debt financed to optimize the return on equity.

Be prepared for regulatory changes

The Infrastructure Debt asset class is affected by increasing regulation overall and the desire of regulators to provide investors with more transparency and information. For example, the European Commission is intensively pushing the issues of sustainability and climate change.

• One result is the EU taxonomy - a classification system designed to provide a common wording and a clear definition of "sustainable" business activities. This is intended to guide investments to achieve the European Union's 2030 climate and energy targets.
• Meanwhile, the Sustainable Finance Disclosure Regulation (SFDR) requires funds to disclose how they are increasingly incorporating sustainable practices into their activities and clearly defines which strategies qualify as sustainable investments.

In June 2021, a survey of private markets investors by Preqin found that the most important reason fund managers adopt ESG is investor demand for it. This underscores the critical role that infrastructure debt investors can also play in addressing the climate crisis and achieving carbon neutrality. However, the challenge with unlisted companies is often access to sufficient ESG information, whereas with listed companies there is usually a wealth of data that provides insight into the emissions profile of investments, for example. For non-listed companies, this does not currently exist to the same extent. In addition, many industries have not yet defined common methodologies, reporting guidelines and metrics, making it difficult to assess progress. Investors therefore still have to spend a lot of time and resources gathering information from borrowers on areas such as greenhouse gas emissions or alignment with the EU taxonomy.

Digital: growing demand for the infrastructure of the future

In the infrastructure sector, digital assets are in greater demand than ever before. Fibre-optic networks and data centres are in high demand. However, the Covid 19 pandemic, with a sharp increase in video conferencing for businesses and streaming services for the home, also highlighted the deficits in digital infrastructure. According to the latest OECD study, for example, Germany is in one of the last places with a share of only 5 percent of fibre-optic broadband connections.

However, there are many more nuances to consider when it comes to business models. This is because competition for digital infrastructures has increased significantly. For investors, the market segment presents exciting opportunities, but also harbours risks. Long-term investors therefore need to take a close look at the assets they invest in to ensure that they are appropriately positioned to respond quickly and adequately to a changing environment as market conditions change.

Infrastructure debt: compelling long-term investment opportunity

Investments in infrastructure are urgently needed worldwide. Even though the political situation and the market will remain challenging, for example due to rising interest rates, we are still in a low interest environment in which infrastructure financing can be an interesting long-term, sustainable investment.

Banks, traditionally among the largest lenders, prefer shorter-term financing and have reduced the amount of long-term financing due to regulatory hurdles. This opens the door to institutional investors, especially those whose assets face long-term liabilities. Demand and volumes are high for infrastructure financing - as are growth opportunities.

Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable at the time of publication. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail. This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). The Summary of Investor Rights is available in English, French, German, Italian and Spanish at https://regulatory.allianzgi.com/en/investors-rights Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, www.allianzglobalinvestors.co.uk, deemed authorised and regulated by the Financial Conduct Authority. Details of the Temporary Permissions Regime, which allows EEA-based firms to operate in the UK for a limited period while seeking full authorisation, are available on the Financial Conduct Authority’s website (www.fca.org.uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.