Infrastructure Bonds: Why Consider Them?LinkedIn
There, in black and white
NB Bulletin Vol. 15 N. 3, January 2012
Pension funds are now—more than ever—looking for secure, long-term assets that produce a high steady rate of income. For several years now, bonds related to infrastructure projects, particularly those structured as public-private partnerships (PPPs), have become increasingly popular and have taken on a growing position in bond indexes. For some organizations, certain values or ideologies might render these investments inappropriate. However, they have characteristics that meet the needs of many pension funds to manage their mismatch risk and some institutional managers have set up funds dedicated to infrastructure debt.
According to a 2007 survey conducted jointly by the Federation of Canadian Municipalities and McGill University, there is an enormous deficit in the Canadian infrastructures sector. In order to improve or maintain existing infrastructures, investments in the order of $123 billion are required. This amount rises an additional $115 billion when new projects are taken into account.
The current outstanding amount of infrastructure bonds is over $45 billion, and they represent more than 40% of corporate bonds with a 10-plus year maturity. There are two types of infrastructure bonds: traditional bonds and PPP bonds. The outstanding amount of bonds related to PPPs alone will reach $20 billion shortly, which is double the current outstanding PPP debt according to a study by the Royal Bank of Canada.
Traditional bonds are issued to finance infrastructures that operate mainly in the public services sector (renewable energy, waste water treatment) or transportation (bridges, roads and airports). Examples of frequent issuers of bonds rated AA to BBB are NAV CANADA, Aéroports de Montréal and Hydro One Inc. Considering their more traditional structure and significant weight on the DEX Index, these securities represent good liquidity relative to other infrastructure bonds in Canada.
PPP Infrastructure Bonds
Governments are increasingly resorting to PPPs to finance, structure and operate public service infrastructure projects. A consortium of builders, operators and financiers is selected by the government to carry out the project, after a formal call for tenders. The government can therefore transfer the risks of construction, operation and financing to specialized firms. The government then usually takes possession of the asset and operations at the debt maturity.
To finance a PPP project, consortium members usually provide equity often representing 10% to 20% of the project. They finance the balance by borrowing on the markets and issuing long term bonds. The PPP bonds generally have a 30- to 40-year maturity and a credit rating of AA to BBB. The credit risk is concentrated on the construction period, where cost overrun risks are carried by the companies part of the consortium. After the construction period, which usually runs four to five years, interest and principal payment is contractually secured by the government. There is a risk related to operating costs during the post-construction period and it depends on the consortium’s competency to properly evaluate the long-term operating costs.
PPP bond yields are more attractive in the first few years following issuance, i.e., about 5% to 6%, then quickly decline once the construction period has ended, potentially resulting in capital gains. Examples of PPP bonds are the super-hospitals in Montreal, such as the McGill University Health Centre (MUHC) and the Centre hospitalier universitaire de Montréal (CHUM), the RCMP headquarters, and Highway 25.
The main risk of PPP bonds is the credit risk. The complexity of financial structures, contracts and guarantees require specialized expertise in infrastructure project analysis to reduce this risk. Another important risk to consider is the liquidity risk, as a more complex structure means such bonds are bought and sold less frequently on the secondary market. An increase in the number of investors and standardization of bond structures are factors that progressively improve liquidity. In addition, the risk of concentrating in the same sector should be considered.
Infrastructure bonds have attractive features for pension funds and this corporate bond market sector is expected to grow in the coming years. The long maturities, the steady high income and the quality of bonds issued in sectors overseen by governments are good reasons for investing. If you want to learn more on infrastructure bonds, please contact one of our consultants.
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