Infrastructure Debt: A niche strategy
There are many reasons why infrastructure debt should feature in LDI strategies for UK pension funds. But do not expect a huge growth in allocations, says Joseph Mariathasan
At a glance
• Infrastructure debt looks a suitable asset class within LDI strategies.
• There are issues concerning infrastructure debt in LDI, including credit risk and diversification.
• However, a key concern is limited supply.
• The impact on funding is expected to be limited.
When real yields on UK index-linked Gilts are negative at every maturity, matching inflation-linked pension liabilities becomes an expensive proposition. Yet there are alternative investments that offer inflation matching and with positive yields. Infrastructure investments with very long maturities, very stable and often inflation-linked cashflows can seem the ideal investment, particularly for pension funds with liabilities stretching out 50 years or more. It is perhaps surprising that there has not been more take-up by pension funds, given the long-term nature of infrastructure.
Infrastructure debt investments do appear to be gaining favour as a liability-hedging instrument. But there are obstacles that need to be overcome: “People will only be able to hold a small amount of infrastructure due to both supply and liquidity concerns,” says Simon Wilkinson, head of LDI funds at Legal & General Investment Management (LGIM).“From an LDI perspective, whilst these assets definitely have a place in a de-risking portfolio in terms of providing a higher yield and contractual cash flows, there are credit-risk implications, which require diversification. If pension schemes are going to derisk, they are pretty much risk averse. If they have an LDI focused derivatives overlay, schemes need to consider diversifying counterparties. The last thing they would want to do is to invest large amounts into one piece of infrastructure.”
Clearly, for infrastructure debt to be a suitable LDI asset class, pension funds need to be able to gain exposure in a risk-controlled and diversified way.
In 2011-12, the UK government set up an initiative to encourage pension funds to invest more in domestic infrastructure, leading to the creation of the Pension Infrastructure Platform (PIP). As chief executive Mike Weston explains, PIP is owned by the UK’s Pension and Lifetimes Savings Association (formerly known as the National Association of Pension Funds). PIP has just launched a fund targeting £1bn (€1.26bn) in two portfolios – a low-risk pure-debt portfolio offering retail price index (RPI) plus 0-2% and a higher-risk debt-plus-equity portfolio offering RPI plus 2-5%.
Individual ticket sizes for investments are expected to be between £50m and £75m. Schemes that invest more than £50m are able to co-invest with PIP into larger transactions. Smaller schemes can invest a minimum of £1m, which gives them an opportunity to obtain a pooled exposure to infrastructure. The focus is purely on UK infrastructure as a low risk investment suitable for LDI: “There are plenty of infrastructure opportunities overseas, but you then end up taking political risk and currency risk which then requires more returns to justify the risks, leading to a very different investment proposition to what is required for LDI,” says Weston.
Other firms are also targeting UK infrastructure as a replacement for index-linked Gilts or corporate bonds. Macquarie Infrastructure Debt Investment Solutions (MIDIS) is launching its second fund mandated to invest in UK inflation-linked infrastructure debt. The launch follows MIDIS’ £829m close of the first ever UK inflation-linked infrastructure debt fund, which is now in the latter stages of deployment.
Tim Humphrey, managing director of MIDIS, finds that there is significant unmet demand for investment grade inflation-linked debt from UK infrastructure borrowers, across a range of subsectors including utilities, renewable energy, transport, health, regulated social housing, student accommodation and local authority projects, “There is good visibility of an inflation-linked pipeline of about £4bn a year with significant upside potential, particularly with a number of large transactions in the pipeline,” says Humphrey. MIDIS has managed to capture around £1bn of this pipeline for its clients over the last 18 months across 18 transactions.
“People will only be able to hold a small amount of infrastructure due to both supply and liquidity concerns”
However, a significant proportion of borrower demand for inflation hedging continues to be met by entering uncollateralised inflation swaps with banks, which are increasingly expensive and pose counterparty risks. With pension schemes sitting on the other side of these swap transactions the opportunity for disintermediation is clear: “Inflation-linked debt is particularly attractive for pension schemes, since attractive yields have persisted despite significant inflows of insurer money into infrastructure debt, which has largely been targeting nominal debt markets,” says Humphrey.
In addition to yield and diversification, Humphrey sees such debt as offering valuable LDI benefits: “In our first pooled fund, the assets are long-dated, with maturities ranging from 18 to 40 years, and the vast majority of cashflows are linked to inflation. By holding £100m in our fund’s portfolio, rather than assets which provide no inflation hedging, we estimate that a pension scheme is freeing up £10-20m of cash or Gilts earmarked elsewhere in the portfolio to support inflation hedging under traditional LDI – the scheme can then deploy this £10-20m into assets which similarly earn an illiquidity premium. This benefit, combined with the ability to access inflation hedging on terms which are better than swap markets, can add up to as much as 50bps per annum when expressed in yield terms”.
For a typical pension scheme, substituting index-linked Gilts with long-dated inflation-linked infrastructure debt can, over the life of those investments, serve to close a funding deficit by 15% to 20% of the amount of the reallocation. This is particularly attractive for pension schemes, argues Humphrey, as even a modest allocation within the portfolio can have a meaningful impact for a pension scheme.
Infrastructure debt is not risk free, but it compares favourably with investment grade credit, which many UK pension funds are willing to use in LDI strategies. Humphrey refers to a Moody’s study, which shows that infrastructure debt has performed significantly better than investment grade corporate bonds.
Investors typically lose 50-60% of their investment when a corporate bond defaults; in infrastructure, the average loss is less than 20% because lending is generally to entities with high barriers to entry and regulated or strong contractual revenue streams.
Such borrowers are frequently restricted in terms of the activities they can undertake and hence in their ability to raise new debt, either by lender covenants, authorities or regulators.
There is also an increase in credit quality in the long term with these entities because projects have maturity and exhibit very low defaults once an infrastructure project is operating smoothly.
Despite the attractions of infrastructure debt in LDI strategies, there are drawbacks. As Alex White of Redington argues: “The problem with infrastructure is that the assets are more like garnish; it does not provide the meat of what LDI is supposed to do. It can be a refinement at the edge of your portfolio but you are never going to have it large enough to be able to move the dial.”
Infrastructure investment is never going to make the difference between succeeding and failing in paying your pensioners, White adds, whereas getting LDI right can easily do that.
Wilkinson concurs: “If you think about the numbers in terms of assets moving into LDI and what is really going to move the dial, these products would have little overall measurable impact due to supply constraints. You are not going to be able to approach the massive amounts required in asset classes like infrastructure. The government is issuing significant amounts of debt and the pension schemes are still happy to buy it, and we have a well-functioning derivatives market which is also pretty good for LDI.”
In conclusion, infrastructure looks a good asset for LDI purposes, but pension funds should not be rushing out to sell all their index-linked Gilts just yet.