The Trials And Tribulations Of The EC's Project Bond Initiative

By Brendan Malkin

Everything seems to be up for grabs. The EC and the EIB spent between last September and February of this year road showing its Europe 2020 project bond initiative, a scheme which aims to encourage investment into the European project bond market. On May 3, it completed its public consultation on the details of the scheme, and now it plans to publish a comprehensive proposal on project bonds next month. However, the market seems to be as much divided now as ever it was on how the scheme will work. Also, not everyone is convinced that the two European institutions will be able to get the scheme off the ground by its deadline of 2014.

The scheme is about encouraging private sector investment into the project finance market by means of credit enhancing project bonds. The EIB and the EU hope to achieve this by providing either, or both, guarantees and mezzanine debt that will enhance the credit rating of the project finance bonds. In the process, they hope to make the senior tranches of the bonds more attractive to potential investors.

Few disagree that, in principle, this is a great scheme. After all, there is a vast need for new infrastructure. In its consultation document the EU said that between EUR1.5tn and EUR2tn are need between now and 2020 to finance a wide range of infrastructure-related assets, including transport, distribution and transmission networks, and also new energy generational and broadband capacity. These figures roughly match those published by the World Bank in 2009, which said that USD2tn was needed annually to finance global infrastructure.

Also, new ways of financing infrastructure are needed. Today, Europe almost exclusively relies upon banks to finance new infrastructure. This cannot be healthy. “It should never be a situation where everyone is going only bank or bond,” said one senior industry source. In addition, the need for considering bonds more seriously is growing as banks today are less willing to lend long term debt than they were, say, five years ago. Also, Basel III will make it harder for banks to lend as much in the future.

The need for alternatives to banks is also reflected in the sheer number of projects – similar to the project bond initiative – currently being looked at. These include Hadrian’s Wall, which is currently fundraising for a fund which will acquire the junior portion of a debt facility to credit enhance the senior tranche. There is also the Loan Guarantee Instrument for Trans-European Transport Network Projects (LGTT) scheme, which provides guarantees in case of losses occurring during the early operating stages of projects. It is also understood that at least one monoline is considering launching a new product in the infrastructure market.

History, also, has shown that project bonds can work, and this is most clearly shown in the non-European markets. Municipal bonds are commonplace in the US, and bonds are also popular in Canada where there is a healthy investor appetite, particularly from pension funds, for such funding structures. Australia, too, has a history of using project finance bonds. Mark Dooley, senior managing director focussing on PPPs at Macquarie Capital, said that during the 90s and early 2000s bond financing dominated Australian accommodation PPP, with around 30 PPPs closed in that way, the majority of which were not monoline-wrapped. The reason for this, he remarked, was that “through this period the Australian bank market would not lend much beyond 15 to 20 years, leaving bonds with a significant tenor advantage”. In Europe, many deals were financed using monoline-wrapped bonds. The EU and the EIB hope that their scheme – to credit enhance bonds – will have the same effect as the monolines’ wrap.

Uncertainty Over Structuring Of The Project Bond Initiative
Notwithstanding all of the above, there is a large group of people in the infrastructure industry who believe that the EU’s project bond initiative will probably never get off the ground. And to illustrate their argument they point to fundamental problems within European project bonds.

Firstly they point to the issue of negative carry. This works in the following way: on a bank funded deal, project companies draw down on credit lines provided by banks as and when they are needed. Project companies, as a result, only pay interest on the amount they have borrowed to date. In a bond funded deal, however, project companies receive finance for the entire project in one lump sum on the day the bond is issued. Therefore, they start paying interest to bondholders on the whole amount from day one. They can mitigate these cost liabilities by placing the money they don’t want into an interest bearing account. However, the amount they pay in interest to bondholders is always much higher than the amount they receive from these safe investments, hence the existence of negative carry.

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