COVID-19 has made life harder for already yield-starved investors, and each asset class faces its own challenges. We draw on the latest thinking from our Real Assets House View and research team to highlight where reliable income sources can still be found in real asset markets.
Real assets span a vastly diverse universe, including real estate, infrastructure and private debt. Less liquid than public bonds or equities, these investments have been sought by investors seeking an illiquidity premium, or the benefit of asset security. The current outlook for each of these sectors is particularly complex, with income drivers affected in different ways by the economic lockdown and social distancing measures.
Long-income real estate has historically performed well in difficult periods; benefiting from long-term, contractual leases that are less economically sensitive than other sectors. For those working with a ten-year horizon, our analysis suggests it is attractive on a risk-adjusted, relative value basis. Where tenants are of a high quality and remain solvent, cashflows should be stable and relatively unaffected by short-term economic disruption.
Assets let to high-quality counterparties, like those in the public sector, have a broadly positive income outlook. Long-lease supermarkets also look comparatively well placed as ‘stay at home’ orders have increased demand for groceries. Further out, though, there may well be a continued shift towards online food ordering at the expense of physical store sales.
Figure 1: Finding resilience in long income real estate
In other areas, COVID-19 has brought new uncertainties. As the pandemic began to bite, many educational institutions shifted teaching online and closed facilities and accommodation. It is not clear how long social distancing might last, impacting take-up rates of student accommodations for the next academic year. Assets with university rental guarantees give landlords some protection against short-term drops in occupancy rates, but it remains to be seen whether more students will ultimately choose online tuition.
At the higher risk end of the spectrum, hotels will suffer as many already operate with high fixed costs and thin margins. Sustained social distancing will cause a significant hit.
Ultimately, there are likely to be substantial changes across different sub-sectors. In logistics, occupiers may look to boost supply chain resilience and hold more inventory post-COVID, which would be positive for demand. In offices, the shift towards home working and flexible office space might accelerate. That is likely to mean rental income reflects changes in market rents more swiftly, while the quality of ‘core’ space could become more significant.
We are also mindful of challenges in retail, where weaker retailers in secondary locations may not return at all as the shift online accelerates. In these areas, demand might disappoint, but the fortunes of higher-quality retail destinations could be very different.
Seeking infrastructure income
Infrastructure has attracted institutional demand for its income-generating characteristics. Using the same ten-year reference horizon, our model suggests unlevered subsidised UK renewables will deliver higher expected returns than other asset classes, albeit with more risk.
Perhaps unsurprisingly, non-discretionary services like utilities and subsidised renewables are showing the greatest resilience. Data transmission and storage assets also have utility-like characteristics, just like water or power networks, as data access has now become an essential public service. Conversely, there has been greater uncertainty in sectors experiencing major demand shocks; in transport, for example, in ports and airports, or in renewables with more exposure to price risk.
Figure 2: Relative winners in infrastructure
For those exposed sectors, the resilience of infrastructure debt is likely to be tested in the coming months. In the past, infrastructure debt experienced less rating migration and lower losses than corporate credit. This was in part due to the strong covenants and mandatory cash reserves in typical infrastructure debt structure. While sudden revenue reductions may result in some technical defaults, liquidity will be key to prevent payment defaults or restructurings. A few sponsors are proactively engaging with lenders early and acting quickly to assess how to manage any income shortfall. However, this approach is not widespread. Ultimately, essential infrastructure is likely to receive support from shareholders or, in the last instance, governments.
Other private debt opportunities
One other consideration for income-seekers is the premium to be found in senior-secured fixed-rate private debt, with comparatively low risk. Investors with more risk appetite may find higher income in floating-rate debt, particularly mid-market loans, although there are downside risks.
The outlook for the illiquidity premium in the private loan market is clouded by the scale of government intervention in the bond and loan markets. The emergence of government-backed loan guarantee schemes in response to COVID-19 represents a significant departure from previous crises.
In France, for instance, the government has offered to guarantee up to €300 billion of corporate loans this year. Considering the average flow of credit to companies for the three years to 2018 was €168 billion[i], the scale of intervention is clear. In the UK, help is available to businesses that generate more than half of their income from trading.
Each country has its own rules and exclusions. These conditions could present opportunities for non-bank lenders. Bank funding costs remain relatively high, and banks are expected to manage down their exposures to free up capital for new transactions. This should offer scope for others to finance highly rated private debt transactions across Europe.
As with the financial crisis, the economic fallout from COVID-19 is expected to lead to a reassessment of investment risk right across the real asset spectrum, along with a greater focus on deal structures. Attractive and resilient income sources can still be found, although granular analysis is needed to take account of varying prospects at a company, sector and market level.
As a final observation, when considering how to generate resilient income from real asset portfolios, it pays to have an eye on longer- term trends. Growing demand for data network capacity as companies migrate activities online; evolving distribution networks using robotically-mastered warehousing; or the climate science underpinning the pivot to renewables all present opportunities. Positioning for them can help generate the comparatively stable income so valuable to savers and pensioners over the long run.