[authors: Rizwan H. Kanji, Lidia Kamleh]
Introduction - The Story So Far
In the late 1990’s project bonds were considered the next big source of funding for projects. High profile, investment grade transactions were everyday occurrences. Various financial institutions and commentators were of the opinion that due to financial institutions’ internal credit limitations and risk aversion policies, and the increasingly higher value of funding needs to finance projects, project bonds would continue to grow to meet the funding demand for project finance. However, during the boom years, the syndicated lending market became far more competitive with the financing options both from a pricing and tenor perspective. This competition resulted in project bonds not quite catapulting to the fore-front of project financing.
In 2008, the financial crisis resulted in the virtual collapse of the inter-bank lending market and severe liquidity shortages in the banking industry. This in turn affected the syndicated lending market and resulted in a substantial “tightening” of the market. For the first half of 2009, proceeds from all new project financings in Europe, the Middle East, and Africa totaled US$24.3 billion, a 69 percent drop from US$79 billion during the same period in 2008.
The Appetite - Going Forward
The Organisation for Economic Co-operation and Development (OECD) estimates approximately US$70 trillion will be needed globally by 2030 for infrastructure projects involving telecommunications, road, rail, and urban public transport, water, and electricity.
Middle Eastern nations have announced and embarked on various mega projects ranging from toll road, energy and infrastructure projects in the last few years. While the syndicated lending market is still finding its feet and by no means at the free-flow levels seen prior to the financial crisis, various sponsors are considering project bonds as an alternative or additional source of project financing. A number of recent transactions such as the US$2.23 billion Ras Laffan Liquified Natural Gas Company project bond issuance, the UAE’s Dolphin Energy’s US$1.25 billion project bond issuance, and the recently completed project sukuk (Shari’a compliant project bond) by Saudi Aramco Total Refining and Petroleum Company (SATORP) have provided an impetus to sponsors to consider project bonds, particularly for projects in the Middle East.
Project Bonds?
The question for project sponsors is not whether project bonds should be used but how project bonds may be incorporated into a project’s capital funding structure. There are a number of factors that project sponsors should consider in relation to project bonds.
Competitive Pricing
Historically, financing through a bond compared to loans has been relatively less expensive. This changed prior to the financial crisis and is currently subject to the volatility of the debt capital markets.
One of the key historical points for driving down the cost of funding through project bonds was the credit rating enhancement tied to monoline insurance guarantees which ensured project bonds were highly-rated (typically triple-A rated).
Monoline insurers were attractive because they allowed originators of project bonds to raise funding from investors at lower interest rates as they were “wrapped” by the monoline insurer and hence guaranteed by an insurer with optimal credit rating. They were also attractive because, once “wrapped”, the project bonds typically became more liquid and investors viewed the insurers as having undertaken most of the due diligence to determine whether the project was a ‘good’ investment.
One of the critical characteristics of monoline insurers was their credit rating. However as a result of the financial crisis, and due in part to the monoline insurers’ direct exposure to the subprime assets, the rating agencies downgraded the credit ratings of many monoline insurers and this began the demise of the practice of “wrapping” project bonds.
Despite the demise of the credit rating enhancement provided by monoline insurance, many projects in the Middle East are sovereign or quasi-sovereign in nature and, accordingly, the loss of credit rating enhancement provided by monoline insurers may be mitigated. Furthermore, it is fair to say that the cost of borrowing from the debt capital markets remains relatively beneficial compared to the syndicated lending market, despite the absence of monoline insurers’ guarantees.
Refinancing and Tenor
The mega projects have a relatively long gestation period before income from the project commences to flow through. Accordingly, the financing of these projects should ideally be long-term. Previously, the syndicated lending market for projects was relatively long-term however subsequent to the financial crisis, and for reasons discussed previously, the syndicated lending market typically provides funding for short-term tenors. From a borrower’s perspective, this development creates refinancing risk, specifically during the gestation period of the project. However, the project bond market provides funding on the basis of relatively longer tenors which substantially mitigates the refinancing risk that projects may be exposed to when funding from short-term sources.
Regulatory and Tradability
Project bonds provide a means of financing that may have a beneficial impact on the capital adequacy ratio of the bond investors compared to the lenders to a project through the syndicated lending market. For example, the limits placed on financial institutions may be overcome through project bonds.
Additionally, project bonds retain some allure due to the fact they are a tradable debt security which investors may be able to divest and produce liquidity with relative ease and frequency compared to the opportunity of selling down a lender’s exposure to a project through a syndicated loan.
Issuance Process
It is fair to state that the issuance process of project bonds requires more time and effort compared to project financing through the syndicated lending market. This is essentially due to the fact that project bonds are securities and, therefore, require compliance with securities laws and exchange listing rules and regulations. However, once issued, project bonds generally require less maintenance compared to project finance through the syndicated lending market. Therefore, over the long term, the perceived increased cost of issuing project bonds may be off-set by the lower maintenance costs post-issuance and perhaps also the cheaper cost of funding compared to the syndicated lending market.
Conclusion
Project bonds may play an important role in project financing, particularly as an alternative source of project financing and, at a minimum, a complimentary source of funding to a project’s existing capital structure. Standard & Poor’s Quarterly Spring 2011 provides:
“We believe a reduction in banks’ lending capacity is likely to reinforce the longer-term trend of disintermediation, or greater reliance on public debt markets and other nonbank funding sources.”
