1. What are project bonds?
Project
bonds are private debt issued by a project company to finance a
specific off-balance-sheet project. Because the project company’s
only purpose is the project, project bonds are an asset-based form of
financing. Project bonds can be placed publicly or, most oftentimes,
privately.
Today’s
project bond market is concentrated in the US and Canada; issues in
Europe and emerging markets are still seldom.
2. Who needs project bonds?
Project
bonds are necessary from both the borrower’s and the investor’s
point of view:
First,
bank lending capacity has and will become ever more limited, due to
increasing capital requirements and liquidity constraints for
commercial banks as well as tight public budgets. This is especially
true for long-term financing, which is, nevertheless, fundamental for
an economy’s competitiveness, productivity, and long-term growth.
Second,
from an institutional investor's (pension fund, insurance company,
etc.) perspective, there is a strong demand for long-term investment
opportunities. However, bond markets for very long maturities are
oftentimes underdeveloped.
Project Desertec
3. Project bond concerns
Riskiness
of project bonds
Project
finance is characterized by the following factors:
- off-balance-sheet financing (e.g. usually non-recourse vis-à-vis the sponsor);
- longer maturity, compared to corporate loans;
- higher leverage, compared to traditional corporate finance.
All
of the above make the investment more risky for an institutional
investor because they typically invest exclusively in high-quality
assets.
Debt
origination
A
general remark is that bank loans are faster and cheaper to deliver
than bonds. Indeed, bonds require a rating and the respect of a
specific issuing procedure (namely marketing documentation), which
increases time and transaction costs. The result is that project bond
financing is often inefficient for small transactions.
Another
challenge related to bond debt origination is the fact that
deliverability and pricing of project bonds are unknown until actual
issuance of the bond, As a matter of fact, this might counter the
typical public bidding process (“Certain Funds Period”). In
addition, public authorities can lack necessary project bond know-how
which will enhance this issue even further.
Finally,
bonds are settled upon issuance. This can contradict the financing
needs of the project company that will usually need funding spread
over the whole construction phase and, as a consequence, will cause
cost of carry of early provided funds.
Loan
vs. bond administration
Compared
to traditional bank financing, bonds carry a certain number of
disadvantages:
- The confidentiality of bank loans is higher: For one, possible restructuring negotiations are lead out only among a limited number of banks. In addition, bond markets need, even in the normal course of business, higher disclosure requirements to bridge the information asymmetry between investors and issuer and to compensate for the close monitoring that is common place in case of bank financing and lacks in case of bond financing.
- Bond financing terms are usually less flexible than bank loan terms and conditions. Moreover, the administration (prepayments, waiver proceedings, etc.) of bonds is normally less flexible than the administration of bank loans. For example, in case of bank financing, an agent will coordinate voting processes within the banking pool. This function is usually missing in case of bond issues.
Liquidity
of project bond markets
Oftentimes,
project bond markets lack infrastructure and liquidity. This can lead
not only to bond pricing dilemmas but also to a more difficult
refinancing of bonds.
Dhukwan Project
4. Solution proposals
Riskiness
of project bonds
The
riskiness of project bonds can be moderated by two basic means, e.g.
by modifying the structure of the debt itself or by providing credit
enhancement.
The
first method refers to debt tranching, thus cutting the overall debt
burden of the project company into different pieces and conceiving a
priority order of repayment. This solution, however, will necessarily
make the financing structure more complex and, as a consequence,
potentially shy away investors.
The
idea of providing credit enhancement tries to alleviate the
off-balance-sheet character of project bond financing. De facto,
credit enhancement gives investors indirectly access to the balance
sheet of third parties such as project sponsors, commercial banks,
state-owned or supranational development banks, and debt service
reserve funds. In legal terms, third-party support can be arranged
particularly as a letter of credit, guarantee, stand-alone facility,
or sub-participation. The EU/EIB 2020 project bond initiative might
serve as an example here. The downside of this second solution is
that is operates in the shadow banking area: Because credit
enhancement usually constitutes, from a bank's perspective, an
off-balance-sheet item, it runs against current attempts to reform
the stability of financial system.
Debt
origination
The
administrative origination process can only be shortened through
standardization. As far as possible, such standardization should
apply to any stakeholder in the origination process. Examples include
rating methodologies for project bonds and a legal framework for SPV
issuers.
To
promote project bonds, it will be necessary to amend public tender
regulation. By way of explanation, it is essential that the bidding
process specifically closes out the uncertainty linked to size and
pricing of bond issues. What's more, firm underwriting by investment
banks can also ensure a certain funds period for the project.
Excess
funding at the outset of the project can potentially be avoided by
deploying MTN programs. Obviously, the high costs for preparing a MTN
program imply that this solution can only apply to large-size
projects.
Loan
vs. bond administration
If
not already provided for in mandatory bond regulation, a legal
structure for efficient bond administration should be put in place by
way of contract. Standard forms for loan agreements should serve as a
template here.
Creating
conclusive incentives for investors may also help to enhance the
administration of bonds. As a matter of fact, if investors can
benefit from straightforward bond execution, they will also enhance
their efforts to ensure efficient administration. Incentives could
include
- Link credit enhancement and the assigned rating to bond administration processes (Example: Reduction of credit enhancement in case a waiver is not treated during a specific time period.)
- Link coupon rates to the efficiency of the bond administration
- Extend simple majority decisions as much as possible
Liquidity
of project bond markets
Liquidity
of project bond markets can be built up by taking the following
initiatives:
- Create a capital market infrastructure for project bonds, allowing a more efficient placement, listing, trading, and settlement
- Encourage private investment in project bonds by providing a supportive investor regulation
- Attract foreign investors to domestic project bonds by setting tax incentives such as lower interest rates on interest income and by canceling withholding tax requirements on interest payments
- Favor market making activities for project bond markets
Resources:
- Scannella – Project Finance in the Energy Industry: New Debt-based Financing Models, International Business Research 2012, pages 83 et seq.
- S&P Rating Direct – How Europe’s New Credit Enhancements for Project Finance Bonds could affect Ratings, November 13, 2012
- Sawant – Emerging Market Infrastructure Project Bonds: Their Risks and Returns, Journal of Structured Finance 2010, pages 75 et seq.
- European PPP Expertise Centre – Financing PPPs with Project Bonds, October 2012
- Lam, Chiang, Chan – Critical Success Factors for Bond Financing of Construction Projects in Asia, Journal of Management in Engineering 2011, pages 190 et seq.
- European Commission – A Pilot for the Europe 2020 Project Bond Initiative, October 19, 2011
- European Commission – Regulation Proposal Europe 2020 Project Bond Initiative, October 19, 2011
