It has proven to be a slow and laborious process getting the first credit-enhanced project bonds structured in Europe, but the first deals are finally expected in 2013.

As traditional bank lenders cut back on providing long-term project debt – or exit the business line altogether – greenfield project developers know that they are going to need new sources of long-term capital from institutional investors such as pension funds and insurance companies. But these institutional investors remain wary of the risks of construction delays, cost overruns and long-term project underperformance, and are going to need credit enhancement features in order to bring them in on bond deals.

Structures currently being worked on include the Project Bond Initiative from the European Investment Bank (EIB), a subordinated bond fund from Hadrian's Wall Capital, and the Pebble structure being promoted by ING.

These all typically aim to boost bond ratings up to the ‘A’ level, which gives insurers and pension funds some reassurance with regard to cliff risk – the danger of seeing their investment-grade bond holdings drop down into junk bond territory. It has proven to be difficult to get the first deal closed, but bankers express confidence that the first couple of project bond transactions will finally be placed in 2013.

Creating subordination

The Hadrian's Wall Capital concept involves negotiating senior debt for a project, and then splitting it into two pieces. A fund advised by Hadrian's Wall will then invest with co-investors in a subordinated piece, perhaps about 10%, which will have the effect of credit enhancing the senior bonds, typically to the ‘A’ level.

An ‘A’ rating will ease the concerns of investors such as pension funds and insurance companies that the metrics of a project might change, making their bonds drop to below investment grade. This extra cushion of credit enhancement should therefore help persuade investors to buy bonds. Hadrian's Wall will also do the monitoring and reporting on the project, and act as the key point of contact for bondholders.

"There is no shortage of equity from infrastructure funds, insurance companies and pension funds, but bringing in long term capital markets debt is going to be crucial for the infrastructure sector," says Marc Bajer, chairman of Hadrian's Wall Capital, which has offices in London and Pfaffikon, Switzerland.

"It has taken procuring authorities and sponsors a while to adjust to the realities of accessing the bond markets rather than doing what they are used to, which was getting cheap long-dated credit from the bank market," says Mr Bajer.

His fund is currently working on a broad range of deals including offshore transmission owner (OFTO) power generation, private finance initiative (PFI) hospitals, PFI roads, and renewable energy, and he expects to see its first deals close this year.

Hadrian's Wall already has its first fund in place to take the subordinated tranches. The initial investors are Aviva Life & Pensions UK, the EIB, and Development Bank of Japan, which together have committed about £150m ($233.2m). The advisor and fund manager are now actively working towards a second close for the fund, which has a life of 35 years.

Multilateral help

The EIB Project Bond Initiative offers a Project Bond Credit Enhancement (PBCE) facility, though this time set at about 20% of senior debt. The EIB can either buy a tranche of subordinated bonds, or provide a liquidity facility that can be drawn down in case of construction delays, or at any time during the life of the project if there are unexpected problems.

"There are a number of structures being worked on, all based on improving the position of senior lenders by putting in place a subordinated tranche of some sort," says Firouz Momeni, managing director for project bond and private placements at Société Générale Corporate & Investment Banking in London. "We have already worked with sponsors to get indicative ratings on competitive PPP [public-private partnership] tenders, and in terms of the impact on the rating the EIB Project Bond Initiative looks to be the most powerful."

He says the extra cash made available by the EIB is particularly helpful if needed during the construction phase. However, the Project Bond Initiative is initially targeted at projects in the trans-European networks of transport, energy and broadband. So for project bond deals in other sectors, such as renewable energy or prisons, other project bond solutions will have to be used. These include the Hadrian's Wall credit enhancement structure, ING’s Pebble structure, in which a small club of banks would take a 15% first-loss tranche, or bonds without credit enhancement.

Keeping buyers waiting

Clearly the market needs to get a few deals away, after which the expectation is that it will develop quite rapidly. Certainly the demand looks quite strong from the buy side. In February, High Speed Rail Finance in the UK issued a £760m offering, which was not a project bond as such, being fully guaranteed by the HS1 project owners. Nonetheless, the high level of demand illustrates the institutional appetite for long-dated infrastructure paper - in this instance 25 years.

The delays have been more on the supply side, with procurement authorities and sponsors needing to get up to speed. There have even been some bond elements on PPP bids, such as a road deal in the Netherlands late last year, but the sponsors were still able to source enough bank debt, which was cheaper and easier.

It could make sense to do a refinancing of an existing project in order to get a deal done quickly and kick-start the market. But there are problems here too. Project sponsors generally like to lock in long-term costs, and most have signed swap agreements at the start of the project, to pay fixed interest rates over the life of the project. With interest rates having fallen so far, it would now be very expensive to terminate these swap agreements. 

At Moody's, the rating approach for PPPs is to look at the construction phase and operating phase separately, and work out a rating for each, with the assigned rating being the lower of the two.

"The PBCE facility being offered by the EIB is of greatest benefit during the construction phase, which fits well with the EIB's focus on new projects rather than refinancings," says Andrew Davison, senior vice-president at Moody's Investors Service in London. "However, we are also expecting to see some refinancings with the help of some of the other project bond structures that are currently being developed in the market."

"The project pipeline in Europe slowed down as a result of the financial crisis and austerity measures," he adds. "However, we are seeing strong interest in ratings for a number of projects, and the project bond market could grow quite rapidly once the first few deals are completed."

Capital market access

Market participants agree that capital markets access is a vital goal, and to some extent the EIB is in a position to do some political arm-twisting if it chooses, persuading national governments to push procuring authorities in the direction of project bonds and away from bank debt.

"There is a limited amount of long-duration bank debt available, so there needs to be a prioritisation to ensure that there is enough bank financing for projects that really need it, such as those with new technologies or long and complex construction phases," says Scott Dickens, global head of structured capital markets at HSBC in London. "The use of institutional debt can then be focused on assets where the risk profile is more suited to capital markets, such as availability risk."

The first project bonds are likely to be in more easily understood sectors, such as roads or the OFTOs sector, adds Katrina Haley, head of structured bonds at HSBC.

"Institutional investors are already very aware of the infrastructure asset class, even if they may have categorised it as investment in the transport or utilities sectors, and they will initially prefer to invest in sectors that they are familiar with, rather than taking a huge leap into sectors they don't understand so well," she says.

She notes that although most of the talk in the market has been about using credit enhancement to get project bonds up to an ‘A’ rating, in some cases a ‘BBB’ rating could be sufficient to attract investors. Certainly most market participants expect to see the first deals this year.

"The level of interest that we are seeing from both project sponsors and institutional investors is significantly greater than 12 months ago, and the project bond market just needs to get one or two deals away in order to create some momentum," says Simon Thompson, senior associate at law firm Norton Rose in London. 

"There are a number of structures being proposed, but there is usually some sort of credit enhancement element in order to get the senior bonds up to the ‘A’ level," Mr Thompson adds. "In addition to new projects still at the procurement stage, we are also seeing discussions on the refinancing of existing projects that are already generating cashflows – so the first deal could be either greenfield or a refinancing."


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