Introduction

Defined benefit (DB) pension funds in search of secure income cashflows have invested in infrastructure debt.

Better funded schemes have had the luxury of investing in senior, investment grade infrastructure debt where lending margins are lower because of the security from being a senior lender to the highest quality sponsors and against the highest quality projects. Typical lending margins (also known as the credit margin) are 1-2% p.a. above government bond yields.

At the other end of the spectrum pension funds, in search of higher returns to close funding deficits, have invested in junior (including mezzanine), sub-investment grade debt where margins can be significantly higher due to the sub-investment grade nature and, in many cases, the low sub-investment grade nature of this debt. These higher margins are due to the lender standing behind other senior lenders in the creditor queue; facing a lower quality sponsor/project and often accepting that interest and capital are only paid at loan maturity rather than amortised throughout the term of the loan[1]. Typical lending margins are 5%[2] or more than above government bond yields.

In between these two ends of the spectrum, other DB pension funds have invested in so-called "cross-over[3]" sub-investment grade debt[4] i.e. the highest quality part of the sub-investment grade spectrum. To enhance security, they have used diligent asset selection; structural protections in the form of seniority in the capital structure; security against tangible assets; lending covenants (restrictions) and often require that interest and (a portion of the) capital are repaid throughout the term of the loan rather than rolled up to the loan’s final maturity[5]. Typical lending margins are 3-5%p.a. above government bond yields.

Our aim is to cover how, by lending to suitably chosen infrastructure projects and through appropriately constructed lending arrangements, pension funds can earn attractive risk-adjusted returns and simultaneously benefit from secure income streams to help them meet their cashflow obligations.

A common theme in our paper is to encourage pension fund decision makers to look beyond "labels" and focus on first principles when making judgements about the robustness and stability of cashflow streams.

Private[6] infrastructure debt lends itself to customisation of lending terms to improve security for lenders. For this reason, when creating secure income cashflows from private infrastructure debt, investors seeking secure income would be wise to look beyond credit ratings and the traditional dichotomy between investment grade and sub-investment grade debt. Instead they should rather focus on asset selection and structural protections embedded in the lending arrangements.

Private debt differs from listed debt; the former better lends itself to customisation of lending terms and, as will see, is part of the reason that pension funds are embracing the asset class in search of secure cashflows and improved risk-adjusted returns.

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1. Payment-in-kind (PIK) arrangements allow for interest to be added to the capital amount and paid at the final maturity date.
As a result, the loan amount increases over the term. PIK arrangements create a series of forward starting loans for an amount equal to the deferred interest payments. Uncertainty increases with time and so lenders demand a higher credit risk premium for longer term lending. PIK structures therefore compensate lenders for the risk and uncertainty associated with the outstanding loan amount growing as time passes.

2. Typically corresponds to a rating of B+ or lower.

3. Cross-over refers to debt whose rating is on the cusp of investment grade and sub-investment grade.

4. Expected credit rating of BBB- to BB-.

5. Also known as requiring cash interest payments and debt amortisation over the term of the loan.

6. Private infrastructure debt differs from public infrastructure debt. The former is more akin to an “over-the-counter” arrangement where investment terms are customisable between borrower and lender whilst public debt terms are typically not customisable.

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