Infrastructure investment: assessing the risk
April 2019 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2019 Issue
Understanding the past can help inform our present and future decisions. Infrastructure investors often hold this principle in high regard since their interest lies in assets that – among other traits – can typically offer longevity, monopolistic characteristics, low volatility and predictable cash flows.
We, too, share this interest in the asset class’s past performance, which recently led us to conduct several studies into its historical trends. By doing so, it gave some insight into how infrastructure investment has evolved over time against other asset classes; but also – crucially – how likely infrastructure credits are to default.
Our most significant finding? Though infrastructure ratings have displayed negative rating movements (meaning there have been more downgrades than upgrades), they have still been less likely to encounter default than corporates engaged in the production of goods, or non-financial corporates (NFCs). So, although discrepancies exist within each sub-sector and investors must navigate new and emerging risks in the coming years, there is longevity yet in this asset class.
Rating transition by industry
Certainly, our findings tell the wider story of the infrastructure market; one of expansion and resilience. From a market initially concentrated in North America, infrastructure debt has gone global. To put matters into perspective, in 1981, only one of our 319 infrastructure ratings was located outside North America. By 2018, this figure rises to 536 of 1076 ratings.
Of course, infrastructure as an asset class covers a broad range of projects – from greenfield and brownfield, and regulated and merchant, to name just a few. As such, discrepancies within the infrastructure segment exist. For instance, the most rating movement has been experienced in the power industry.
And, among the sectors with at least 100 ratings, power and oil and gas have the lowest ratings – with around half the latter industry holding speculative-grade ratings. Historically, power ratings had almost exclusively been investment grade until 2003, when the rate of speculative-grade ratings increased to 17 percent from 9 percent in the previous year. This peaked at 29 percent in 2016 before declining over the following two years to its current level.
The next most likely sector to experience negative rating movement is transportation. Between 1981 and 2017, the ratio of downgrades to upgrades for transportation issues was 1.68 to 1. Moreover, this sector has seen periods of heightened volatility. For instance, transportation ratings remained at least 90 percent investment grade until 2009 but two years later fell below 80 percent. Since then, the speculative-grade share in transportation has been at least 20 percent.
Utilities, on the other hand, have been less prone to rating movement. Contributing in large part to the sector’s overall high credit quality are regulated utilities, which benefit from a raft of credit-supportive characteristics: being essential services with high barriers to entry (often operating as natural monopolies) and a limited ability to add debt. The downgrade-to-upgrade ratio is 1.24 to 1 – which is higher than for social infrastructure and oil and gas, but lower than for power and transportation. Ratings in the ‘BBB’ category typically move up rather than down over increments of up to five years. Over longer periods this tendency becomes even more pronounced.
This sector has also seen its share of volatility, however. The crisis associated with Enron had a marked effect on utility ratings – and accelerated the higher incidences of degradation in the early 2000s. During Enron’s demise, the rating composition of the utility sector shifted toward the ‘BBB’ category and, between 2000 and 2003, downgrades outnumbered upgrades by 372. Due to heightened credit stress and deregulation across the utility sector between 2000 and 2005, there were 27 defaults – the largest cluster of utility defaults during our study (and this represents more than 40 percent of the 61 utility defaults since 1981).
Default patterns may still vary by industry, but to a lesser extent than rating movements do. There has nonetheless been correlation between rating movement and defaults since the 1990s, thus suggesting that defaults are not random. Instead, they are reflective of rating trends and underlying credit conditions.
For example, the power industry, the most likely segment to experience a downgrade, has had the second-highest number of defaults. Since 1981, we have seen 133 infrastructure defaults – almost all having occurred since 2001. Defaults became most prominent during two periods: the early 2000s (17 defaults occurred in 2002, the most on record); and the ‘Great Recession’ from 2007 to 2017.
But it is not all doom and gloom. Perspectives change once we compare this journey to other asset classes. Indeed, the infrastructure sector made it through the most recent financial crisis largely unscathed compared to other classes. The peak default rate during this period was under 1 percent. For NFCs, this figure rose to 6 percent. Recovery rates for infrastructure debt instruments, too, have been broadly stronger than for NFCs.
A more promising future?
Taking all things into consideration, there is a nuanced lesson for infrastructure investors. What is undeniable is that rating movement for infrastructure has largely been negative: downgrades have outnumbered upgrades 2830 to 2184 through to 2017. One of the most challenging spells came between 2000 and 2004, when there were 712 downgrades in infrastructure, compared with 222 upgrades.
But this fact, though crucial for infrastructure investors to remember, may not tell the whole story. In recent years, trends have been more favourable, and the balance of rating movements is shifting. In seven of the past 13 years, there have been more upgrades than downgrades. Two of the years for the highest number of upgrades were 2007 and 2008, during which there were 274 upgrades combined – accounting for 13 percent of all positive rating movements since the 1980s.
What next for this market? In the years ahead, infrastructure will not be exempt from new and emerging risks. On many continents, investors must navigate uncertainty over nationalist and populist movements, which may scupper market confidence. Changes to regulatory frameworks also pose new challenges. That said, investors, we believe, can still find comfort in the favourable characteristics that have long attracted them to the asset class.
Candela Macchi is director and sector lead in the Infrastructure Ratings Practice in Latin America at S&P Global Ratings. She can be contacted on +44 (0)20 7176 3605 or by email: firstname.lastname@example.org.
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