ASEAN investor roundtable: Project bonds face long-term challenge

PANELISTS:

Fazil Erwin Alfitri, president director, Medco Power Indonesia

Boo Hock Khoo, vice-president, operations, Credit Guarantee and Investment Facility

Sean Ramsey Lee, fixed income portfolio manager, Affin Hwang Asset Management

Arup Raha, chief economist, CIMB

John Simon, treasury and capital market director, CIMB Niaga

Nor Masliza Sulaiman, global head, capital markets, CIMB

Andrew Steel, managing director and head of Asia Pacific,

corporate ratings group, Fitch Ratings

Edwin Syahruzad, financing and investment director, Sarana

Multi Infrastruktur (Persero)

Krishna Syarif, director of investment development, BPJS

Ketenagakerjaan

 

Moderator: Rashmi Kumar, editor, GlobalCapital Asia

Asiamoney (AM): Dollar rates are expected to move up gradually while prices of commodities futures have rallied since the beginning of the year. How long will this rally continue? Does this development change your economic outlook on Indonesia?

Arup Raha, CIMB: How long are commodities going to stay firm? — That’s a million dollar question. It’s very hard to answer but I also don’t think it’s that important in determining interest rates. Our belief is that commodity prices will soften as some of the rise you are seeing is due to an uptick in Chinese activity, which is likely to fade in time. After all, there is a structural downturn. Of course, the path from 10% growth to 5% growth in China is not linear so you will see ups and downs which will be reflected in commodity prices. Secondly, there are some supply issues that have come up, especially with oil, which may or may not persist.

But for the purposes of this discussion, we can safely assume that the best days for commodities are over and have been since 2011. So the question is, what is the future for the Indonesian economy? I think the outlook is positive. Commodities have probably knocked off 1%-1.5% from GDP growth. So if you talk about 5% growth, it could probably have been higher at 6% to 6.5%. But 5% is not a bad number if that is what we will get. The question is how the economy will realign itself. There is a desperate need for building infrastructure, because with infrastructure you will make all parts of the economy, especially manufacturing, a lot more productive. The next stage is that we need funding for infrastructure. The savings are there but we need to make the savings more long term and channel it through the bond market into long-term activity. Once you start getting infrastructure going, manufacturing becomes more productive. So the future will be good but different. And the next few years are going to be crucial to make the right kinds of investments to be able to capture this future. AM: Do you see economic and fiscal reforms undertaken by president Jokowi as capable of increasing foreign direct investment into Indonesia?

Raha, CIMB: If you look at FDI in Indonesia, in rupiah terms, the growth is around 20%. And even in dollar terms we’ve seen 3%-5% growth over the past few years and among the main investors, the biggest is Singapore. But we know that Chinese subsidiaries use Singapore to invest so it could be Chinese companies. The second highest is Malaysia, followed by the Netherlands, Japan and China. So a large amount of the FDI is already coming from Asia. And Indonesia is pretty open to be able to invest. The restrictions are more on what the returns are, what the criteria etc are. But to give you an idea, FDI is almost double domestic direct investment. So FDI is not the issue, it is to be able to take domestic savings and create longer-term savings, and then channelling those savings into longer-term projects.

AM: Given the government’s commitment to boosting infrastructure development, what more can be done to channel these savings to provide more fundraising avenues for infrastructure companies, especially as there is a high dependence on bank loans?

Nor Masliza Sulaiman, CIMB: There is a lot that can be done on the disintermediation of credit where investors can partake in the credit upside of projects rather than being captive to banks. For issuers, there will potentially be a saturation of LLL (legal lending limit) because if funds are raised at a corporate level, you will have the banks being full in terms of LLL with the respective sponsors and the typical promoters.

So where do you go from here? From an investor point of view, there needs to be a leap of faith supported by a very thorough education process on project bonds and its risks. To get here, on the government side and from issuers’ perspective, concessions need to be very clear and stable. There should be sanctity of contracts and the ability to generate stable cash flows, where the rating agencies can have a clear methodology and come up with their respective ratings. This aids investors to price the bonds equitably. In short, issuers will enjoy better pricing because there is direct participation from investors, where potentially the end game is availability of long term funding allowing for better matching of project cash flows, which gives better IRR to the sponsors. Investors will be able to lock in long term returns at favourable rates rather than lose out to banks.

AM: How critical is the constraint of single lending limit on banks in funding infrastructure projects? How do you think Indonesian banks will benefit if long-term financing requirements of Indonesian corporates could be achieved by long-term bond issuance?

Andrew Steel, Fitch: The short answer is that if the project bond markets take off, then it clearly helps single lending limits for banks in Indonesia. One of the issues for bond market development is that the bank single lending limits are relatively generous. They are certainly in line, if not slightly better, than what you see elsewhere around the world. And that is not very helpful for the development of the corporate bond market. One of the major hurdles that needs to be overcome if we want to move to more project bond financing is that – to put it bluntly – the banks need to stop lending for this type of transaction too cheaply. There needs to be an acceptance that the trade-off for having this long-term certainty of financing, with all the contractual obligations that go with it, is that there is realistic pricing of risk to create a level playing field across the market.

AM: One thing that issuers look at closely when reviewing their various debt-raising options is cost. How does the pricing available in the local currency debt market compare with what infrastructure companies can get from bank lenders?

Sulaiman, CIMB: That’s a very good question. Currently, bank loans do not match the project cash flows and are typically for tenures of five to 10 years, leaving the project sponsors vulnerable to refinancing risks on both quantum and yields. Investors and issuers can work together and match that gap to push the investment to a longer-dated maturity that matches the sponsors’ project cash flow. Then you will have an optimal win-win scenario with project sponsors and investors. Given the current shorter dated bank loan financing, there is no direct comparison. But simplistically, if you look at a 10 year AA-rated bond curve and where the banks are lending, there is easily a spread of about 1.5% to 4% that could be shared with project sponsors and investors so the value proposition is definitely there.

Sean Ramsey Lee, Affin Hwang: If you go longer across the curve in the Malaysian market, say 15 year or 20 year bonds, we can get 5% to 6% in terms of returns, which is a decent pick-up against other risks. Also, a lot of the funds we have come from pension funds that have requirements of high realised return targets of anywhere between 5% and 6%. And it’s essential that we do clip these kinds of coupons. So it is something that bodes well with our appetite.

Edwin Syahruzad, SMI: We are a triple A rated company, so we deserve financing costs in local currency that might be closer to the government bonds yield. We have issued five year corporate bonds before when we had a double A plus rating, so the bond was fairly priced and we attracted investors as a first time issuer. But when it comes to financing costs, we are also supported by equity money from the government so we have some luxury in providing financing to our clients. We have very competitive pricing in terms of rupiah long-term financing and investment. We are also not required – unlike other private equity or infrastructure funds – to provide satisfactory returns. We are geared more towards the public or development mission. So that’s why we can be a friendly partner to infrastructure operators and developers in the country. Fazil Erwin Alfitri, Medco: If you see what is available in the country, I would say we don’t have much choice. Most of the time, developers like us have to take whatever is available in Indonesia from the project financing aspect and we try to manage it so it doesn’t kill the project before it starts. Typical project financing for us is going to be in rupiah, and may be at around 10.5% in IDR. But if it is in dollars, depending on the quality of the project and the project sponsors, then it costs 12% plus. That is the kind of pricing we are looking at.

But for a typical project, the return is not on the high side – it is mostly in the lower teen’s level. So it is very important to help find a win-win solution. Mind you that financing for infrastructure projects in Indonesia is relatively new and very young – it just started after the Asian financial crisis. So there is not much alternative out there available for developer like us unlike say in Malaysia, where you can look at various options. So we try to manage and take what we can get and find a win-win solution with the lenders.

Boo Hock Khoo, CGIF: For project companies, the only financing option is a bank loan for most jurisdictions today and it is hard to make a comparison of the costs mainly because the interest rates for loans are likely to be floating while bonds are generally fixed. For project bonds, the pricing depends on where benchmark interest rates and the spreads are. While there is little one can do about benchmark rates, spreads vary considerably and need to be at reasonable levels.

Local investors should look at internal capacities to take risks and price spreads at reasonable levels. If you look at what is happening in Indonesia, from the 8% risk-free rate, you get an additional 2% spread for triple As. So the additional work you need to put in to earn the spread relative to the risk-free rate may not be that compelling. But imagine if benchmark risk free interest rates are 3%, then spreads become more critical and sought after.

This is what happened in the Philippines where high interest rates were observed in the past but now they are at 3% to 4% levels. So the work that is needed to earn that additional one or two percent really needs to be put in context with where benchmark rates are. I can’t predict where rates will be in Indonesia but I think it is useful to start building this capacity to start having the yield pick-up or be in a position to do so.

Sulaiman, CIMB: Locally, most project based financing is raised at the corporate level as most of the common sponsors are highly rated. Given the LLL constraints, this may not be sustainable to fund the anticipated volume of infrastructure projects. Although some lower rated sponsors have good infrastructure track records they may not be able to fund infrastructure projects as efficiently at a corporate level. This is because if you’re raising it at the corporate level, even though the project cash flows come from the government or paymasters that are potentially highly rated, there’s contamination of credit and funding the project at the corporate level becomes more expensive. Ring fencing the project cash flow not only gives more reasonable pricing and is LLL efficient for the project sponsors, it also provides investors an upside when the credit gets upgraded post completion risk. So it’s a win-win solution for funding infrastructure projects on a large-scale basis, because multiple infrastructure projects can be funded simultaneously across a larger investor base. AM: At the inception stage, high grade and highly rated infrastructure bonds will arguably provide a strong motivation for investors to hold these bonds. How would a guarantee from a body like CGIF help project sponsors and investors from the perspective of project development, risk mitigation and advisory?

Khoo, CGIF: Guarantees and guarantors are often misunderstood. Recently a guarantee was described to me as similar to the icing on a cake. I found this to be an interesting analogy as customers don’t go to a cake shop to buy icing. So a guarantor’s role is to build confidence in a particular project. The guarantor has certain standards before it is able to provide that guarantee and once it’s able to do so, bond investors can buy the bond, not purely based on the guarantee itself but based on the fact that the project has been well scrutinised and will be well monitored. Also, if you have a bad cake, no icing can make it good; as such a guarantee should not be used to wrap bad projects.

While we currently guarantee the whole bond, eventually what we aim for is to guarantee certain tranches with other tranches of the project issued to investors as standalone bonds. Investors would benefit from a guarantor’s structuring and consent management roles, if controlling rights are given to the guarantor particularly during the construction phase. Most importantly, investors in the non-guaranteed bond would ride on the fact that their interests are also aligned with a guarantor that has risked its capital in the same project or having “skin in the game”. Our ultimate goal is to see projects well structured and investors having the confidence and expertise to buy into these projects eventually without needing a guarantee.

AM: There’s been lots of talk about the tax amnesty bill and how some of that money can go towards buying infrastructure bonds sold by construction companies. How would that change the dynamic of the local currency bond market?

Syahruzad, SMI: I don’t want to put an estimate on the repatriation money impacted by the policy initiative. I would rather speak about the challenge faced by Indonesia to get the benefits of this policy. The availability of liquid and high grade instruments, bonds in particular, would be a necessary condition for attracting this offshore money into Indonesia. To reach that situation, linking projects with finance is key and for that reason, the availability of credit enhancement and risk mitigating instrument is key to a broader bond market. Infrastructure is a very specific single asset and there is some risk that has to be recourse to the sponsor.

For example, at SMI we try to provide cash deficiency support facility. In this way, lenders are not exposed to too much risk as by providing this subordinated tranche, we can tap limited recourse investors, making it a good environment for project bonds in the future. We are also trying to replicate the success of European investment banks whereby they are creating subordinated tranches to provide enhancements to the senior loan. So by providing enhancements or A/B loan risk mitigation to the project, we can collaborate with underwriters like CIMB to issue or originate a project bond. SMI is an agency that always encourages originating PPPs so we are here to provide some special or complementary tranches to the senior loan. But the most important thing is to improve the investment climate for infrastructure.

John Simon, CIMB: The quantum of money that the government is expecting is huge, not to mention the possibility of a credit rating upgrade. So if I was one of the guys that wanted to bring my money back, the possibility of an upgrade is an additional incentive. Project bond is good as it’s about being at the right place at the right time. The worry now with such a large amount of money coming in is how we can channel it. Project bonds would be able to provide us with an avenue to avoid the complications from LLL. Although the LLL restriction is mostly on the banking side, it would be nice as investors or the non-banking side to be able to see that bankers are also able to go in without being restricted by names on a project basis. AM: Long-term savings in the pension fund industry will be the key to funding long-term investments in the country. But the size of Indonesian pension funds is still relatively small when compared to the size of funding requirements. How can pension funds respond to this challenge and what are some of the viable options to mitigate these problems?

Krishna Syarif, BPJS: There are lots of challenges for the pension fund industry. What we expect this year is an increase in the role of the government, especially Indonesia Financial Authority (OJK) and also the Ministry of Finance, to do more financial ‘dynamic' reform and continuous financial deregulation. From the beginning of the year, OJK has issued a new regulation that the financial sector must comply with a certain percentage of government bonds in their portfolio. Our portfolio requires at least 50% in the format of government bonds and some industries require at least 10% or 20%. So the role of the OJK and the Ministry of Finance is very important on how to improve the bond market. We also expect new incoming regulations, such as reverse repo rate and capping of banks’ deposit rate, to create a positive effect in the market by reducing deposit rates and generating growth of the real sector.

This is very crucial and significant to how we can improve the bond market and how we can boost economic growth in infrastructure. Nowadays, most big institutions put all the money into deposits (with short-term tenor) so Indonesia has become a country with one of the highest domestic savings rates in the region. This had happened for the last 30 years. The huge domestic saving is actually a potential resource to finance infrastructure projects and we may reduce our dependency on foreign and US dollar based funds. What really matters now is mutual understanding between all parties in the government and how we proceed with the new incoming regulations. We believe pension funds and other parties will support and comply with any incoming regulations and may leverage the current good economic conditions. AM: Affin is one of the fastest growing asset managers in Malaysia. What do you consider the main attractions as well as concerns when it comes to buying project bonds or bonds supporting infrastructure?

Lee, Affin: From a Malaysian perspective, a large portion of our infra bonds have been coming from toll roads and power plants. Generally as bond investors, we look for stability. We want stable credits with decent returns, and infra projects offer stable cash flows. Matching your cash flows with liabilities is one of the most important things. So once a project has been successfully delivered and operation and maintenance is moving forward, that should be the key consideration of what makes bonds attractive. Delving more into toll roads for instance, we’ll definitely look at traffic volumes. On a historical basis, most of our urban highways have traffic volumes that are at least close to projections. For power plants, on the other hand, we are comfortable with the fact that the offtaker is Tenaga Nasional Berhad, which is a solid offtaker. The bond is structured with a lot of bond holder protection and features, from ring-fencing to financial coverage ratios. So that’s what gives us a lot of comfort.

In this environment of low inflation and low growth, where everyone is looking for yield, a trend we have seen is that investors are looking to constantly extend duration. They are comfortable with it and know that interest rates will not rise at least over the near term. And extending duration will actually enable you to achieve those kinds of returns, which is positive. The concerns we have are the pre-completion risks, cost overruns or delays in projects. There can always be hiccups. For example with toll roads, it can be relatively difficult to forecast traffic volumes. Sometimes the forecast can be a lot more aggressive when compared with what happens years down the road. In terms of power plants, you can get unplanned outages that last a lot longer than expected. Some of these power plants are single projects. So if there is difficulty finding solutions, investor gets concerned. And what that leads to ultimately is the chance of a downgrade. Again from the Malaysian perspective, these bonds tend to be AA3 or double A minus rated by local agencies. If they are downgraded, they will fall into the single A category, which renders it helpless against liquidity. As bond investors, you buy the bond and expect not to hold it for a 30 year period. So you do want some liquidity and once it drops to that kind of rating, the chances are it will never see daylight again.

AM: Are triple-A rated project bonds considered as strong as triple-A rated corporate bonds? What risk mitigation features do bond investors look for, and are these met by the current Indonesian framework?

Steel, Fitch: The simple answer is yes, they are directly comparable. The whole purpose of a rating scale is to compare relative risk and propensity for default across sectors, countries and different industry types. One of the issues with infrastructure bonds is the level of time, complexity and cost involved in structuring those bonds and putting them together. We were talking about what might be done to help facilitate more infra bonds and how that might stimulate investment in infrastructure in Indonesia, but one of the biggest obstacles is there isn’t really a first mover advantage to do this type of bond. No one really wants to spend the money, time, cost and effort to put in place the first infra bond, because there isn’t any payback for that extra cost and effort.

Whoever follows that first bond will get most of the benefit because the lawyers can take the existing documentation, amend and adapt it for the new deal, and the whole process becomes a lot quicker and more cost effective. What we have seen elsewhere is actual support for the costs involved in putting together the framework for the initial infrastructure deals. What we have also seen are instances where banks in western economies in particular, will fund the construction risk phase and then flip the bank debt into a project bond once the construction risk is completed. One of the main reasons for doing this type of mini-perm (or refinancing risk) structure is that bank debt is usually more flexible for dealing with issues that can arise during the construction phase and so this ‘splitting’ can be a very good method.

For a project bond to be rated AAA or AA and to have an equivalent rating with a corporate rated at that level, the actual structuring and risk allocation are very complex. Each individual aspect is easy enough to understand, but when you put them together and try and work out the balance of those risks, that’s where it becomes complicated. And that’s where support from groups like CGIF on aspects that are peculiar to the transaction or the industry is very useful. For instance, if we are looking at the structure and information on the project, we expect there to be a technical adviser who confirms that the project is feasible and who looks at the realistic outside costs, answering questions such as: is it a cost effective project and how does it compare with other projects around the world? Does it actually work and how certain are they?

When we look at completion risk, we look at things like the complexity and scale of the project – the more complex it is, the harder it becomes to allocate and analyse the risks. We look very closely at contract terms and hopefully there is an engineering procurement and construction contract which wraps the entire construction and makes it the responsibility of one party. If not, then again it becomes much more complicated. We look at contractors’ expertise for this type of project, implementation track record, potential replacements, the credit quality of the contractor themselves and any structural enhancements. All of this is with a view to how the risk carried by the contractor can be effectively mitigated if there is a delay in the project or cost overruns.

I could go on describing the multitude of other individual risks but you get the idea — there are a huge number of risks, the interaction of which creates a very complex overall risk profile. We examine this risk profile and if the protections and the structures are in place and robust, then it’s perfectly possible to achieve a very strong rating and the risk of a downgrade is actually very low. If structured robustly this type of asset is very suitable for asset managers, pension funds and insurance companies who look to make long-term stable investments to match their liabilities.

AM: What do you think would encourage issuers to take the plunge and sell a local currency infrastructure/project bond versus opting for other funding solutions?

Alfitri, Medco: As a power developer, our options are limited. Our typical approach is project financing, but you have to make sure to find debt. And here, just lenders are able to see if they can accept the project based on the sanctity of contracts, the strength of the project sponsor etc. But from our perspective, that means giving everything that you have to the lender. For the first 10 years, we were working with the banks, which means that for every project that we have, we don’t see the money for the first 10 years. The bank holds the money until all the loan has been paid and then you start seeing the cash flows. This is where a project bond is very interesting as it will enable us to manage our cash flows better. So this kind of thing is something that we are keen to follow up.

Syahruzad, SMI: We are not a true project bond issuer since we are a non-bank company. But from the liability side, infra bonds will give us access to long-term finance. It’s one way to obtain a long-term fixed rate financing from the capital markets. And that’s basically our main objective — whether it is local currency or global bond issue since we also accumulate assets in US dollars. We were established to be complementary to the banking system or, in the future, to bond investors. In Indonesia, the possibility to originate a limited recourse finance project is quite limited.

Let’s take the example of a toll road. During seven years of operation, they are still running with negative net income and negative cash flows. So the sponsor has to top up the money to pay down the principal and interest to senior lenders even though the tenor of the senior loan is 15 years. So in that case, a project bond may be suitable because it gives way for sponsors to have less top-up or guarantee equity to the project itself. SMI’s mission is to create tranches that are complementary to bonds so that bond investors can be more reliant on the cash flows of the project.

AM: What local regulations and market conditions should be enhanced to drive growth of the long-term local currency bond market, particularly project bonds?

Sulaiman, CIMB: To show our commitment in growing the local project bond market, we pledge to co-invest with local investors. Project bonds are not without their fair share of risk and one of the major issues stems from project completion delays. As arrangers, when necessary for safe measure, we have built in time buffers of six months to one year to pre-empt delay in delivery beyond the project sponsor’s control to ensure that there is sufficient buffer in the cash flows and the bonds’ cash flow profile to afford time delays. We also add in contingency funds if need be, to the quantum of 5% to 10% of the project cost, so if the project cost escalates, it is within projections. An interesting point to share is that Malaysian investors are willing to fund the interest during construction and that provides higher structuring flexibility to sponsors where debt-to-equity is typically kept within 75% to 80% of the project financing. We’ve also seen risk participation from project sponsors but it is on limited recourse and if any, commonly structured during the construction period.

Most project bonds are structured as non-recourse financing where investors benefit from higher returns on both the project bonds’ credit and a longer maturity profile matching the project cash flows. The project sponsors have an acceptable IRR to undertake the project, leaving them with more opportunities to recycle their capital to fund more infrastructure projects. Project bonds may experience negative rating actions if there are events that compromise the quality and timeliness of the project cash flow and as arrangers, we monitor the project bonds we originate very closely and will work with project sponsors to engage rating agencies. If there are delays and issues over and above what we have structured into the cash flow assumptions, we will, on a proactive basis, work with project sponsors to restructure the project finance bonds and work with investors so that we can come up with a win-win solution.

Steel, Fitch: One of the aspects we are trying to work out on this panel is how do you get that first infra bond off the ground. One of the things I’ve seen that’s enabled this in other countries is to have a bank that’s prepared to put in the upfront work and does this working very closely with a large pension fund, or an asset manager that is prepared to be an anchor investor in that bond. In this way they work together to create something seeing longer-term benefits in doing more infra bonds in the same style. There needs to be an incentive to do that of course because it is expensive.

People often talk about PPP transactions in the same breath as infrastructure development generally without making any clear distinction between the two. Usually there is no volume or pricing risk in PPP transactions. It is a very stable government-led framework where if you build the asset and it works how you said it would, you receive an availability payment, and as long as it operates satisfactorily over the period, you keep getting the payment. There are penalties if it doesn’t work how you said it would work and there are also incentives if it works better than that, but, you are not taking the price and volume risk. These are the kinds of projects that you need to try to do to kick start infrastructure investment and build a track record in this kind of a market. They are ideal as initially investors don’t have to deal with the additional risks and complexities of making assumptions about volume and price for the sector they are dealing with, which in emerging markets can often itself be in a transformational stage of development.

Khoo, CGIF: With regards to regulations, I think there are two parts. First of all, there is a lot of confidence in the Indonesian government, based on the government bonds that are well bought. Investors don’t buy the current administration’s bonds and dump those issued by the last administration. So the promise to pay by the government is whole and sound. When we come to concession agreements and promises of other sorts, there is a big gap between the government’s promise to pay on its bonds and the concession terms it gives out.

So drawing on this parallel, how can the government give investors comfort that the 30-year concession it writes today will be whole and sound? It’s really not that difficult. You just need to have clear policies for each sector; clear policies of how the private sector can invest and how the government is going to protect their investments over the long term. In fact, the government can have sectors that are far more appealing than what the country ratings indicate, with policies that are attractive and stable that investors would come in irrespective of the country ratings. Secondly, project bonds are a different asset class. One should not sell a project bond the same way as you do a government bond or a corporate bond. In developing this new asset class, we cannot issue an offering circular and a few weeks later, ask for orders. This can happen in mature markets with a rating report but in emerging markets, no investor is going to just pick up an offering circular and say I’m going to dive into this project bond, for 20 years, without doing due diligence, visiting the site, looking at cash flows or contractual agreements. So I would encourage the regulators to carve out project bonds under a separate asset class and allow investors more information and access to the projects. A project will likely take two years to put together anyway so why speak with investors in the last few weeks to financial close?