EDHEC-Risk has posted a fascinating new paper about credit risk in infrastructure investment.
The paper, co-authored by Frédéric Blanc-Brude, and Omneia R. H. Ismail, speaks to a public policy question that has received a hearing in several countries since the crisis of 2007-09. As Blanc-Brude and Ismail put it, “should pension funds and insurance companies invest significantly in new infrastructure projects?”
Governments sometimes have difficulty financing through their Treasuries public work projects that they nonetheless believe will “play a role in supporting future economic growth.” In such contexts, governments are tempted to re-jigger incentives so such institutions will channel their money into new projects. As an example, the authors make reference to the recent request by the European Commission that the European Insurance and Pension Regulator consider lowering the Solvency-2 capital requirements to accommodate such long-term investments: energy, transport, water and sanitation, government buildings and such.
On the other hand, pension funds and insurers have been less than thrilled by the idea. The title of this paper is “Who is afraid of construction risk?” The title, though perhaps indicating that the authors are admirers of Elizabeth Taylor and/or Richard Burton, is also their way of suggesting that investing institutions are afraid, or are at least overly cautious, especially of the new “green field” projects.
Their wariness is not irrational. Infrastructure debt is distinct in important ways from the regular corporate debt with which they’re more familiar. This is not solely a matter of the special-purpose entity structure. As a bottom line concern, infrastructure debt has longer maturities and lower spreads than corporate bonds, “with a high degree of statistical significance,” they say, citing a 2005 study by Stefanie Kleimeier and William Megginson.
The dynamic in the infrastructure world combines high initial leverage with a process of deleveraging that lasts through the life of the asset, and the authors document how that plays out as time passes.
The paper deliberately sets to the side issues of accounting or infrastructure debt valuation which, the authors say, will be the topic of another forthcoming paper.
The gist of their argument, though, is that investment institutions should get over the fears and get into the infrastructure game, chiefly because it adds credit-risk diversification to the portfolio.
Specifically, in lending money to an infrastructure related SPE just as in buying a bond from a corporation, the lender/buyer has to concern itself with the probability of default. But in the latter case, there is an element of predictability. The probability of default is dependably highest in the early years of the project, and declines to near zero in the later years. See the figure below, a striking illustration of this point.
This helps explain why investors are especially wary of the green fields. But it also explains that perhaps they shouldn’t be. Both ends of that curve can play a role in portfolio construction. There ought to be, in other words, lifecycle diversification.
The authors of “Who’s Afraid” include a discussion of how the data base for making decisions on infrastructure investors might improve. Scientific portfolio construction, they say, “requires benchmarking each dimension of the risk/return trade-off using the most appropriate proxies." This, in turn, requires [service providers] to revolutionize the way project and loan data is collected and stored at financial close and on an ongoing basis.
A complete specification of loan risk would entail data at the loan level, at the project level, and at the macro level and data for each year from origination. Only when such data is available will the optimal investment solutions be designed.
Blanc-Brude is research director at EDHEC Risk Asia, he also heads the Institute’s thematic research program on infrastructure investing.
Ismail is senior research engineer with EDHEC Risk Asia and works within that research program.