The £2.8 billion ($5.17 billion) takeover of Associated British Ports and the launch of a string of structured products investing in curious...

The £2.8 billion ($5.17 billion) takeover of Associated British Ports and the launch of a string of structured products investing in curious debt structures suggest investors (and their advisors) are broadening their search for sources of income.

They are not remotely interested in standard bond yields of 5 per cent pushed down by switches from equities to bonds by maturing pension schemes. The US Federal Reserve is set to push interest rates to 6 per cent to control inflation and inflation-linked bond yields are close to record lows.

The removal of some surplus liquidity from the market, particularly in Japan, has also undermined confidence in equities, particularly in emerging markets. A sharp uptick in volatility in May reminded investors that equities could fall as well as rise. A record number of initial public offerings have been pulled.

Soggy bonds and volatile equities have further convinced investment banks, relentless in their search for profits, that the securitisation of corporate cash flows makes this an excellent source of fees.

Transport particularly fascinates them, as does real estate. Other sectors will follow, as long as corporate earnings yields remain ahead of returns from bonds.

The transport theory runs that ships will continue to ply their trade around the world, whatever the state of global economy. Passengers will drive their cars on motorways. Airlines will continue to pay their landing fees.

The banks have gone on to convince themselves that the income generated by ports, motorway tolls and airports is secure. The data suggests that tolls rise in line with inflation. And they repeat these arguments as they sell the income streams produced through infrastructure securitisation to institutional clients. Better yet, companies like AB Ports own large areas of surplus land, capable of creating property profits.

It so happens that many institutions will be paying fees not far removed from those charged by hedge funds to invest in infrastructure funds. Many will be repurchasing the very assets they owned as former shareholders of the original listed companies. Transport users, regulators or governments, are quite capable of protesting about rapidly rising tolls in an inflationary environment: the likes of Ryanair have turned protests against rising costs into an art form.

But the cutting and dicing of risks and returns into neat packages to suit current perceptions commands higher premiums than they should. The conversion of property companies into real estate investment trusts is also set to demonstrate the point investment banks are good at marketing products with limited capacity and recent data on returns from infrastructure (and real estate) is impressive.

Hard on the heels of the purchase of the British Airports Authority by a Spanish consortium, AB Ports is being bought by those clever people from Goldman Sachs (in the process of putting together an infrastructure fund) plus the Government of Singapore and an offshoot of the Ontario Municipal Employees System of Canada. The counter bidder was Macquarie, the Australian infrastructure specialist, which has contented itself with the £264 million purchase of a string of London bus routes from Stagecoach, after pointing out that their cash flow was “highly predictable” (which is more than you might say for the underlying service).

Over time, the bidders of transport companies can be expected to sell infrastructure income in tranches, according to the level of security on offer. Debt finance has a role to play for assets which stay on purchaser balance sheets, as is the case in the private equity industry, where the issue of relatively risky mezzanine debt in Europe hit a staggering €9 billion in 2005, equal to sums issued in the previous two years combined.

In an attempt to finance the very riskiest part of a deal, infrastructure, private equity or real estate players often resort to issuing junk bonds, stub equity or yet more risky paid-in-kind securities, which helped fund the purchase of Manchester United Football Club by the Glaser family. As with transport, the financiers took the view that ticket purchases by Manchester United fans were a “highly predictable” source of income.

Higher risk securities are increasingly finding their way onto the wider market through the structured products being eagerly lapped up by wealthy investors in search of an income to cover their lifestyle.

This year has seen the launch of a new generation of offshore listed vehicles by providers like Wharton, Cheyn Capital and Cambridge Place who have cut and diced returns to offer access to gross returns stretching as high as 10 per cent.

Getting to that return isn’t necessarily a problem when the income from underlying investments is nearly all paid out by way of dividend. Stretching to this yield does, however, require an appetite for gearing (four times is not uncommon) and recourse to an esoteric basket of credits whose underlying liquidity cannot be entirely guaranteed.

Many of these structured products will deliver on their promises, assuming the economy continues to grow. Some will fare less well: frequent recourse to debt issued by real estate entrepreneurs is worrying, given the sector’s notorious booms and busts over the years.

But the crucial point to make about corporate restructurings, and the current investor attitudes is that the financing of transactions is increasingly reliant on techniques used in the bond markets, fuelled by a ready source of capital.

The steady de-equitisation of the stock market harks back to the US, during a period of 1980s, when Michael Milken, formerly of Drexel Burnham Lambert, used junk bonds to privatise some of the largest companies in the US.

But investors being wooed by debt products would do well to recall that a number of listed companies are capable of generating “highly predictable” earnings without any need of restructuring.

If share prices start to drift, there will be no shortage of financial engineers keen to bail out their shareholders. And if inflation and interest rates really lift off, investors will be better off in equities than marooned in a series of esoteric debt products.

Mike Foster is associate editor of Financial News and a contribitor to WealthBriefing.