- The purpose of this report is to provide an overview of the IABS asset class, which remains relatively new to Asia.
- A sponsor sources project and infrastructure loans and underwrites securitized notes to investors.
- IABS can help bridge a funding gap for infrastructure financing.
This is the first in a series of reports on Infrastructure Asset-Backed Securities (IABS) in Asia Pacific. The purpose of this report is to provide an overview of the IABS asset class, which remains relatively new to Asia.
An IABS transaction involves a sponsor and/or manager sourcing project and infrastructure loans from originators (i.e. banks), underwriting them and issuing securitized notes backed by these assets to investors. This helps originators recycle their balance sheets, while offering investors exposure to these projects and infrastructure loans in a credit-enhanced format, enabling them to originate more project and infrastructure loans. For the Asia Pacific region, IABS can help bridge a funding gap for infrastructure financing, which according to the Asian Development Bank (ADB) in 2017, amounts to USD 467bn per annum.
IABS is typically backed by a diversified portfolio of project and infrastructure loans. Long-term investors such as life insurers and pension funds can benefit from matching their long-dated liabilities with longerdated IABS. An investment-grade credit rating for IABS would also fit into the investment mandates of life insurers, pension funds and asset managers. In addition, investors benefit from instant diversification across projects, sectors and geographies/regions, compared to investing directly in individual loans or projects. Furthermore, the elevated credit profile of a senior tranche minimizes the capital cushion that an institutional investor may need to put up against its investments. Last but not least, IABS offers institutional investors access to an asset class with significant barriers to entry, managed by an experienced collateral manager.
As with any credit product, IABS is not risk-free and, depending on how each IABS is structured, IABS could be exposed to loans without public ratings, concentration risk (in certain sectors, countries, guarantors, offtakers and projects), political risk, operational risk of a collateral manager, counterparty risk from loan participation exposures, and prolonged recovery periods in case of loan defaults. It should be noted that such risks are generally taken into consideration in the ratings process of IABS, either through the credit estimate (i.e. private ratings) assigned to the underlying loans or the stress testing of the loan portfolio and IABS structure.
The underlying assets of IABS are project and infrastructure loans that an IABS sponsor sources from banks, multilateral financial institutions and/or project/infrastructure debt funds. The loans are then used to underpin the issuance of notes with different credit ratings according to the expected loss (EL) of each tranche.
Project and infrastructure loans have very different characteristics to traditional corporate loans. Project and infrastructure loans are generally backed by long-term offtake contracts, with loans structured based on expected project cash flows. Project and infrastructure loans are secured by projects themselves and/or by sponsors’ interests in the project. These elements require specialist expertise to diligence and price appropriately. That said, IABS is typically structured to help investors address these credit considerations through specialists’ credit review/ underwriting, diversification, and credit enhancement.
The key elements of IABS’ underlying assets are the following:
1. Overall trend
In recent years, the volume of syndicated loans-to-infrastructure projects has dropped due to a change in banks’ strategic direction to originate and distribute rather than to use their own balance sheet, which is partly driven by credit risk capital charges under the Basel III rules. Hence, IABS will play a pivotal role to help banks recycle capital, thereby facilitating the origination of new loans. This will also offer an opportunity for institutional investors to participate in this asset class, which had been traditionally dominated by banks.
In reviewing the pipeline of private transactions versus closed transactions, we clearly see the need to finance more renewable, conventional power, and transport sectors in Asia.
2. Countries of Risk
Traditional collateralized debt obligations (CDO) usually contain debt concentrated within a small number of countries or only in one investment-grade country. While IABS can span a region to benefit from country diversification, an Asian IABS can have more pronounced country risks and/or exposure to non-investment grade countries. Also, IABS with various country exposures will require analysts to conduct country risk assessments in terms of macroeconomic, political and currency transfer and convertibility risks. EXHIBIT 5 shows the country distribution of the BIC IABS, where the majority of exposure was in investment-grade countries. For the BIC IABS, country concentration risk was mitigated by an appropriate level of credit enhancement, including support provided through the retention of the Subordinated Notes by Clifford Capital, acting as a first loss buffer for the holders of the senior and mezzanine tranches. In addition, such country risk was mitigated as some loans in the portfolio were covered by political or commercial risk insurance provided by highly rated export credit agencies, insurers or multilateral financial institutions.
Project and infrastructure financing in Asia has historically covered projects within sectors such as conventional power, transport, and renewables. 2019 has seen a drop in private sector infrastructure financing activities in Asia (EXHIBIT 7) with the bulk of the decline in financing of conventional power projects. On the other hand, the renewable energy sector has grown steadily since 2015 and we expect greater environmental awareness amongst market participants to drive further ‘green’ loan volumes in the near future.
4. Tenor and cashflow stability
Project and infrastructure loans contained in IABS offer investors more consistent cashflows compared to corporate loans - especially in times of crises such as the current COVID-19 pandemic. The consistent cashflow, often contracted under long-term offtake contracts, compensates investors for the longer tenor of project and infrastructure loans compared to usual corporate loans. In the case of the BIC IABS, the weighted average life (WAL)1 was 5.4 years at the time of issuance, which is roughly 2x longer than what corporate loans usually offer.
5. Implicit/explicit supports and/or guarantees
Project and infrastructure loans offer consistent and predictable cashflows, often with strong implicit support from governments, high-quality sponsors and/or guarantees from export credit agencies or multilateral financial institutions. IABS can contain project and infrastructure loans for which borrowers enter into concession agreements or offtake power purchase agreement (PPA) with government-owned entities, both of which in our view could be construed as implicit government support in certain Asian jurisdictions where the offtakers (e.g. utilities or power distribution companies) are usually state-owned enterprises.
6. Limited construction risk
IABS can contain both operational projects and projects under construction, but predominantly the former since they are cash generative and exclude construction risk. In the BIC transaction, the loan portfolio at inception contained predominantly seasoned loans that had passed the project construction phase and were already operational. Operational projects have a better chance to be rated investment grade by rating agencies as there is more certainty around project cash flow timing. We note that projects under construction can require extensive diligence on construction execution. In particular, Asian country risk varies and project completion risk tends to be greater in countries with greater political risk, which can be difficult to hedge and analyze. In the case of the BIC IABS, 24.4% of the portfolio at inception was under construction, with construction risk mitigated through external credit support. We understand that any construction projects that BIC acquired had some form of completion guarantee or sponsor support as a mitigant for investors.
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