Why "project bonds" are a good idea: Gerard Wynn

LONDON Fri May 25, 2012 4:00am EDT

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LONDON (Reuters) - European Union backing for extra infrastructure finance may sound like a deliberate distraction from deadlock over much bigger euro bonds, but in fact it is a great idea - the trouble is the tiny sums involved and lack of detail.

The "project bonds" idea stems from a two-year-old, European Commission and European Investment Bank (EIB) plan to drive capital market investment in infrastructure.

That's distinct from common euro bonds backed by all countries in the euro zone, which would pool sovereign risk and so protect struggling countries - and which is opposed by Germany.

The project bond idea got a fillip earlier this week, when the European Parliament and EU member states agreed the launch of a pilot phase, pending EIB board approval.

That paved the way for a mention by European Council President Herman Van Rompuy after Wednesday's EU summit, as one way to lift torpid growth.

The aim is to prop up infrastructure finance.

An EU-funded bond would take the riskiest portion of the debt raised by an infrastructure project, and so the first losses, aiming to overcome the natural caution of institutional investors.

That would test-run one way to grab a slice of the multi-trillion-dollar bond market, and so help cover a retreat in bank lending.

The trouble is the scale of ambition so far.

The EIB project bond initiative would have just 230 million euros ($289 million) of EU money in its pilot phase, with no numbers yet for a full programme which may dovetail with the next EU budget round starting from 2014.

That compares with full EIB lending last year of 61 billion euros.

Details are also sketchy: so far the EIB hasn't detailed target sectors, beyond infrastructure projects in energy, broadband internet and transport.

BANK RETREAT

European bank lending to infrastructure projects has fallen since the financial crisis, a trend expected to continue given stiffer, upcoming banking regulations.

The trend varies by sector: bank lending to wind power projects has dropped sharply.

New (Basel III) international banking rules will put pressures on banks' balance sheets, and especially limit the kind of long-term lending demanded by 30- to 40-year infrastructure projects.

That contrasts with a shift in appetite among institutional investors including pension funds and insurance companies towards bonds away from equities, leading to the obvious connection that one (bonds) could replace the other (loans).

"We believe stricter regulations governing bank lending under Basel III ... will bring profound changes to the global project finance sector and the way it pursues funding," Standard & Poor's Ratings Services said in a report published on Wednesday, which anticipated a shift to capital markets.

The historical problem attracting capital markets has been that European institutional investors typically limit themselves to investment grade debt.

In the renewable energy sector, that all but rules out involvement: just one European wind project has been deemed investment grade, and was subsequently downgraded to junk.

In other sectors, institutional investors were given comfort by debt service guarantees ("monolines"), arranged by insurance companies, which have evaporated since the financial crisis.

The project bond idea is to split an issuer's debt into several layers, each with a different risk.

A small, subordinated loan would be underwritten by the EIB, using EU money, which would make the rest of the debt appear much safer, allowing it to be securitized and turned into an investment grade "project bond", to be sold to institutional investors.

GROWTH

Bond financing of infrastructure projects isn't new.

HSBC on Wednesday ran a global inventory of climate change-related project bonds, such as low-carbon energy and transport, and identified $174 billion in outstanding notes.

The trouble is scaling this up to levels high enough to meet targets to cut carbon emissions, including the deployment of massive offshore wind farms and capital-intensive, cross-border power grid projects spanning whole regions.

Separately to project bonds, Wednesday's summit also touted a possible increase in the EIB's capital.

That would allow the EIB to borrow tens of billions of euros more on capital markets, to lend on to projects across Europe.

That much bigger lending would also involve lending to infrastructure projects, but under normal EIB terms and certainly not taking first loss guarantees as proposed under the "project bond" idea.

The EU heads of state will make more tangible decisions about the growth agenda at its full summit in June.

The big picture on how far they can boost project finance is unclear. Just how far capital markets step up will depend in part on how far governments are willing to underwrite bonds.

($1 = 0.7947 euros)

(Editing by Jeremy Gaunt.)

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