Key Decisions to Be Taken During Infrastructure Bond Issuance

In the previous few articles, we have studied the distinction between bank loans and infrastructure bonds. We have also come to the conclusion that bank loans are more suited to the construction stage of the project, whereas infrastructure bonds are more suitable when the project has become operational and has started generating a certain amount of cash flows.

However, even the process of infrastructure bond issuance is not straightforward. Instead, there are several key decisions that need to be taken before the bonds are issued. These issues have a long term impact on the life of the entire project.

In this article, we will have a closer look at some of these decisions and the alternatives faced by the company issuing infrastructure bonds.

Fixed Interest Rate vs. Floating Interest Rate

The most important decision which needs to be taken by any company which is in the process of issuing bonds is regarding the type of interest rates that will be used by the bonds. Interest payments are the single largest payments for many infrastructure companies. Here the company faces two options. They can either opt for a fixed interest rate, which may be slightly higher since it provides the option to lock this rate for a long time. Secondly, the company can opt for a floating interest rate. The floating interest rate may be lower than the fixed rate in the short run. However, there is always a chance of the interest rate increase in the future.

Ideally, infrastructure companies prefer fixed interest rates. This is because infrastructure projects generally have a long duration. As a result, infrastructure bonds are known for having a long tenure.

It is difficult for financial analysts to estimate the ups and downs in the interest rate over a long period of time. However, investors are also not willing to accept a fixed interest rate for the exact same reason.

Also, investors do not like fixed-rate bonds because they provide an incentive for the company to refinance as soon as the interest rates reduce. Therefore even if investors agree to a fixed interest rate, they generally levy charges which prevent the company from refinancing the loan when interest rates drop. This creates a fundamental mismatch between the financiers and the infrastructure company. The financiers do not want to lend at a fixed rate, and the infrastructure company insists on having a fixed rate.

To counter this problem, most infrastructure companies use an interest rate swap. This means that they enter into a contract with investors wherein they offer floating interest rates. However, simultaneously, they also enter into a swap contract with a third party. This contract mandates the swapping of cash flows if the interest rates increase or decrease by a certain amount. Therefore, in effect, the infrastructure company has to pay a fixed interest rate.

In many cases, the revenue stream of the project is directly linked to the inflation rate. In such cases, the infrastructure company offers inflation-adjusted bonds wherein the interest rate is derived by adding certain percentage points to an underlying inflation rate.

Amortization vs. Balloon Repayments

Infrastructure bonds can be amortizing in nature, which means that they pay back the principal as well as interest in every coupon payment. Alternatively, they can also be interest-only loans where the principal is paid back towards the end of the loan. This is called balloon repayment.

Both the arrangements have their pros and cons. For instance, if an amortization schedule is followed, then the principal amount is paid back in several small installments. This helps avoid the creation of a cash flow tail, which leads to problems in debt servicing later.

However, from the investor’s point of view, balloon repayments are better. This is because they do not receive principal payments till the end of the tenure. Hence, they do not have to find reinvestment avenues for cash flows, which they receive on a periodic basis.

Lump-sum vs. Development Linked Drawdown

Just like repayment, the timing of cash inflow can also be periodic or lump sum. Ideally, companies would prefer a development linked drawdown of cash. This way, they will only receive cash when they need it. Also, they will not have to pay interest on the excess cash. The problem is that investors do not find it convenient to disburse small amounts of cash each time.

Hence, infrastructure companies are forced to take in cash in one go, and they invest the same in low-risk treasury assets. However, in most cases, the interest that they earn from these low-risk assets is less than the interest they pay. Therefore, there is a negative interest carry which costs the company significant sums of money in the long run.

Some infrastructure companies are willing to offer higher interest rates if their investors are willing to pay them the principal amount in a phased manner.

Historical Cost vs. Mark to Market

Lastly, companies also have to decide about how they will reflect the value of the outstanding debt on their balance sheet. If the bonds are traded in the open market, then they will have to be marked to market since there will be a market price available. However, if the bonds are not traded in the market, they may have to be marked to the historical cost! This decision may seem arbitrary, but the net worth of the entire company fluctuates with the fluctuation in the value of the outstanding debt.

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Infrastructure Finance