Fitch Ratings says that capital and liquidity constraints faced by European banks are hurting their willingness and ability to provide long-term project finance. However, while this in theory creates an opportunity for a project bond market to develop in Europe, challenges are impeding this shift.
Institutional investors may not be fully ready to step up their investments on the debt side, even if the shortage of bank funding now favours a significant development of the bond market for project finance. The unclear long-term future of this new market, the complexity of transactions, and the expected Solvency II capital charges are weighing negatively on the market’s development.
In particular, if investors are only focusing on A rated debt, this will limit the potential size of the market that is more naturally concentrated in the BBB category. With proper understanding of infrastructure finance risks, there is no reason why over time investors would not invest down the credit curve as is the case with other sectors (like corporates), unless regulatory capital requirements are making the investments uneconomic (either for the investors, or for the issuers to adjust pricing to compensate for it).
It is important that the risks are well understood by investors, as well as risk reduction techniques that are used to make projects easier to finance. In practice, risk mitigation generally results in trading one type of risk versus another (in most cases counterparty risk), so investors need to form a view on the type of risk with which they are more comfortable.
Sponsors for both new projects and the refinancing of previous acquisitions are increasingly looking at bond financing as an option. They are starting to adapt to the new landscape, as bank loans had been their preferred choice due to their flexibility and lower pricing. With proper explanation and transparency, bond financing can also have some level of flexibility for issuers.
Governments and supranational authorities are trying, at the highest level, to promote the development of a private sector bond market as they face the tension between objectives to bring European infrastructure to its next level (and to stimulate economic growth) and much needed discipline over indebtedness (on their own account but also for large domestic banks they eventually support). Both the EU and UK in particular have been moving in this direction.
Fitch has attempted to assess what could be the market in 2015 through two different scenarios. In the first, a functioning project bond market gradually emerges. In the second, banks regain their appetite for long-term debt funding, albeit on more lender-friendly terms. In Fitch’s view, the most logical outcome is the first one, although how long it will take to move towards a deep and liquid project bond market is highly uncertain.
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