Solving for Phase II: in a new sector report, analysts at UBS Asset Management’s Real Estate and Private Markets Team (REPM) are casting a bullish eye on European infrastructure credits as major European countries conduct phased reopenings of their economies amid the covid-19 pandemic.
Equity and debt investors have long been drawn to infrastructure assets—private and listed equity and debt instruments in the sub-sectors of airports, toll roads, railroads, oil/gas and renewable energy, utilities, and telecom infrastructure (e.g. cell towers, data centers, and fiber)—due to the group’s relative historic resilience across market cycles and consistent cash-flow generation.
Institutional investors, in particular, have become major holders of infrastructure debt in the years following the Great Financial Crisis. This has been largely in response to the ongoing low-yield environment for traditional fixed income. In many cases, the institutional investor segment supplanted the role of banks pre-GFC, aided in Europe by favorable regulatory changes that incentivized private infrastructure investment in the Eurozone.
“So far in this crisis, infrastructure debt looks to be weathering the storm better than wider corporate (bonds), mirroring the experience of the Great Financial Crisis,” UBS analysts wrote. “We see an opportunity, but are also aware of the risks and the need to select assets that can withstand another wave of infection and a lower growth environment.”
Citing research from Moody’s, UBS noted that just two infrastructure issuers (0.1% of the universe) defaulted between March and May 2020, during the worst of Europe’s first infection wave. This compared to 66 defaults by non-financial corporate debt issuers (1.3% of the universe).
Moody’s has attributed this relative resilience to the “combination of structural considerations and higher revenue stability that characterize many infrastructure issuers.”
But while infrastructure credits showed initial resilience during Europe’s first wave of covid-19, suggesting that the sector could repeat its outperformance relative to broader corporate debt during the GFC, the analysts acknowledged that the unprecedented nature of covid-19—combined with this year’s sharp drop in oil prices— made it tough to predict how the asset class would fare this time around.
Don’t Count Transports Out
Despite a lower GDP-growth outlook and some changes to usage habits, UBS sees opportunities in several European transportation subsectors. They noted that this space performed solidly even pre-covid, with the EBITDA margin for Moody’s European transport sub-sectors coming in above 50%, and with low volatility during the five year period from 2014 to 2019.
” Despite being unfashionable now, these assets will continue to be essential post-COVID, and those investors taking a blanket unfavorable view of these sub-sectors may miss opportunities to secure attractive risk-adjusted return,” they wrote.
Coming into Europe’s Phase II reopening, UBS believes airports—which faced traffic declines in excess of 95% in the hardest-hit regions, along with route reductions and significant counterparty risk during Phase I—could continue to face headwinds.
But on a relative basis, airports with greater exposure to domestic and short-haul (as opposed to international or long-haul) flights, and those less reliant on commercial and retail revenues and dual-till regulation, may be attractive.
Toll roads, on the other hand, particularly those used predominantly for freight transport, were more resilient than airports during Phase I, and may continue to outperform during Phase II, as they continue to benefit from substitution effects away from airports.
Here to stay
The analysts predict that the fiscal stresses of covid-19 are unlikely to dampen public demand for cleaner, sustainable energy across Europe. With the European Commission’s Green Deal aiming to mobilize EUR 1 trillion over the next decade to achieve net zero carbon emissions by 2050, UBS sees “significant opportunities for infrastructure investors” as a result.
This will benefit not only renewable energy sources, but next-generation carbon reduction technologies, storage technology and infrastructure for electric and hydrogen vehicles. Infrastructure buildouts in less mature sectors such as these, they note, will rely on debt capital.
UBS also sees continued robust demand for telecommunications fiber investment—particularly in rural parts of Europe that rely on government aid to finance fiber projects. This was a critical item on European government agendas before covid, and UBS expects this trend to intensify during the recovery.
Data centers, meanwhile, are likely to continue seeing healthy demand even amid a return to physical work, due to demand for low-latency video conferencing and online content applications, as well as business investment in disaster recovery and cloud-based backup solutions for companies bracing for a potential second wave of the virus.
Normal…Whatever That Is
“The biggest uncertainty is how long it will take to get back to normal and how different this new normal will be from the pre-COVID world,” the analysts noted. “If there are no major setbacks and a vaccine is developed within 12-18 months then a strong rebound could be expected but short-to-medium term GDP growth is forecast to be lower than the baseline pre-COVID.”
The fact of this uncertainty, they note, only adds to the investment case for debt, which does not benefit from upside, as the investment case is based upon the repayment of principal and interest in downside conditions. So resilience during the Phase 1 and Phase 2 periods of reopening will be “invaluable,” they noted, in modeling reasonable downside scenarios.
The UBS team is one of the largest real assets managers in the world, with more than $100 billion in assets under management globally.