Distribution of Risks in an Infrastructure Project
Infrastructure projects tend to have a lot of financial risks. In many cases, the risks are poorly managed. In fact, incorrect risk management is one of the main reasons behind the delay, which can cause cost overruns in the long term. It is difficult to reduce the total risk that any infrastructure project faces. However, the distribution of risk needs to be done in such a manner that both parties have the incentive to stop expensive delays and cost overruns. Therefore, risk management in infrastructure financing is all about deciding which party can manage which risks better and then allocating the same to them.
Some examples of poor risk management have been mentioned below:
In many cases, governments have started giving guarantees to the private sector. These guarantees provide a certain source of cash flow, which the private party can take recourse to in case of a cost overrun. The problem here is that such financing arrangements tend to make the private company overly complacent and even inefficient. These guarantees basically insulate the company from any losses which may arise as a result of their inefficiency. Hence, they do not have the incentives to achieve a higher level of efficiency. Also, research has shown that genuine private parties do not look upon the government to insure their risks. Hence, it doesn’t really add value to efficient contractors. Instead, such policies make infrastructure projects a breeding ground for corrupt and politically connected contractors.
In many cases, governments follow the exact opposite of the policy, which has been mentioned above. This means that they tend to transfer all the risks excessively to the private party. The problem here is that the private party is stuck with all the risks, many of which may not even be insurable. Prima facie, this may seem to be a good deal for the government. However, the reality is that it is not! This is because the private contractors end up charging a premium for taking up all the excessive risk. Hence, in the end, the government pays for it anyway!
It is, therefore, clear that giving too much or too little risk to the private sector is an inefficient way. Hence, risks need to be apportioned between the private party and the government. Some of the methods of doing so have been listed in the article.
Distribution of Risks
The best way to distribute risks is to ensure that the party also has a fair degree of control on the parameters which create risk.
For instance, infrastructure projects involve a lot of political risks. It would be incorrect for the government to assume that the private party would be capable of managing such a risk. The government is the party that has maximum control over political factors. Therefore, if a project gets delayed as a result of political issues, it would be unfair to penalize the private party. This is because the private party has no control over the matter. They cannot expedite the project when there are political protests happening or when there are environmental clearances missing. Instead, the project charter should ideally force the government to offer higher compensation to the private party in the event of political risk.
On the other hand, risks related to the execution of the project should be borne completely by the private party. This is because the private party should ideally have complete control over the cost and quality of the infrastructure which is being created. In many cases, the private party may claim that a delay by a third party supplier is causing the problem. However, in this case, also, the private party should be held responsible if it was given complete autonomy while selecting the third party suppliers. The bottom line is that if the private party has some degree of control over the factors which create risk, they will be able to obtain an insurance policy to protect themselves.
There are many risks that are beyond the control of both the government as well as the private party. These risks include interest rate risks as well as exchange rate risks. Interest rates, as well as currency rates, are determined in the international market. Hence, the government cannot really influence these factors beyond a certain extent. Fortunately, there are financial instruments available which allow these risks to be hedged. Derivatives like options, futures, and swaps can be used to mitigate these risks and ensure that the cash flow remains unhindered.
Lastly, since infrastructure projects go on for long periods of time, they may also face many force majeure events. Examples would include events such as floods, drought, cyclones, etc. It is important to account for such events while distributing risks amongst the stakeholders. In most cases, there are insurance companies that make good the loss is such events occur. However, if the loss is not covered by insurance, ideally the government should provide recourse. The government may itself charge a premium and act as an insurance company. However, the idea is to make sure that even acts of God should be managed in the risk management plan.
Hence, it would be fair to say that a private party is incapable of handling all the risks. Instead, the risks should be apportioned between parties that can handle them best i.e., private parties, government organizations, insurance companies as well as financial brokers.
Risks Faced By Infrastructure Projects in Emerging Markets
Infrastructure projects are most needed in developing nations. These are the countries where infrastructure projects are able to create the most growth. This is because the spillover effects of infrastructure projects are felt significantly in emerging markets.
Ideally, emerging markets should create policies that attract more and more foreign investment on to their shores. However, in reality, this is not the case. Emerging markets have a lot of shortcomings. These shortcomings are accentuated during infrastructure projects because of the large scale and size of the investment. This is the reason why institutional investors tend to stay away from infrastructure projects in emerging markets.
Let's list down some of the risks faced by investors when they invest their money in emerging economies.
Currency Fluctuation Risks: Emerging markets tend to have underdeveloped banking as well as equity markets. As a result, they cannot provide all the capital which may be needed for the development of infrastructure projects. As a result, there is a need to involve foreign investors to fund the project. The problem is that foreign investors generally prefer to invest in an international currency such as the dollar or the Euro. However, in most emerging markets, the cash flows are in local currencies. This mismatch often signifies a huge risk for the investors. Since the projects are long term in nature, hedging is also not a viable option. One way to deal with the situation is to involve export credit guarantee institutions of other nations. For instance, countries like China do invest in projects and accept the local currency for payment. However, they insist that the contracts for the project be given to Chinese firms. In many cases, this raises costs and hence, may not be the best option.
Political Risks: Political risks are always present in each and every infrastructure project. However, when it comes to emerging markets, these risks are amplified. In many countries, governments or even rebels disrupt the proceedings of several projects. The disruption could be as simple as not granting permissions for the project. In many severe cases, entire projects have been expropriated by hostile foreign governments.
There are many corrupt governments in developing countries that know that once the infrastructure project is started, the stakes become very high. The projects cannot simply be uprooted and moved to another location. Hence, such governments try to take advantage of taking maximum money out of infrastructure companies in the form of higher taxes or even bribes! Mechanisms such as investment treaties have been created to mitigate political risk. However, they too seem to have limited applicability.
Capital Controls: Emerging markets are also known for imposing capital controls. This means that taking the money inside many emerging economies is easy. However, when it comes to taking the money back out of the economy, there may be several restrictions. Companies may not be able to return the profits earned to their parent company. This means that the investment opportunities for the cash flow generated are also limited. Limited options translate into lower returns and end up scaring away international investors. Also, the problem is that in most cases, capital controls are only put up just before the situation is about to get out of hand. For instance, in Greece, capital controls were stipulated days before the country saw a severe economic downturn.
Opaque Policies: Emerging markets are known to have opaque policies related to infrastructure development. Sometimes political parties keep the policies opaque and muddled up on purpose. This makes it difficult for companies to comply with the norms. Then, they ask for bribes to overlook the non-compliance. Companies that pay bribes are allowed to work, whereas those that do not pay strict legal action. Apart from being unethical, bribes are also known for having a severe financial impact. Many studies have shown that an opaque policy environment is equivalent to a 33% tax on the infrastructure project!
Legal Risks: Each infrastructure projects is a cobweb of several interdependent contracts. It would, therefore, be safe to say that the success or failure of a project depends upon the ability of the infrastructure company to execute the contracts. The problem is that in emerging markets, the legal system does not function efficiently. Hence, there is no downside for many rogue parties if they do not honor their contracts. The aggrieved parties do not have too many legal options. This is because the legal options may be complicated, time-consuming as well as expensive. Hence, the odds may be stacked against the infrastructure company. This obviously is a huge challenge since no investor wants to end up in a scenario where they have agreed to deliver a project with stringent deadlines but are not able to enforce their partners to hold up their end of the bargain. Legal issues can cause severe cash flow problems as it is not common for the payments to be held up because of quality issues or because a certain milestone was not met on time.
The bottom line is that executing infrastructure projects in emerging markets is full of risks. As a result, investors demand a higher return, which raises the cost of the project. It would, therefore, be better to reduce the risks so that the costs can also be reduced and the nation can benefit.
Bank Loans vs. Bonds: Debt Financing in Infrastructure Projects
Debt financing is the most important source of finance for infrastructure projects. In most infrastructure projects, the majority of the project is funded using debt-based financial instruments. Equity holders invest a significantly smaller amount. However, they bear all the risks.
The size and scale of debt financing make it an important decision for any company engaged in developing an infrastructure project. When it comes to debt, companies generally have two options. They can either approach a bank or a syndicate of banks in order to obtain funding for the project. Alternatively, they could also issue bonds and sell the same off to private investors. Each of these methods has its own advantages as well as disadvantages. However, it is generally said that banks are a more reliable source of finance, particularly for infrastructure projects.
Let's compare the two methods of raising debt finance in order to understand what makes bank loans more viable.
The Advantages of Using Bank Loans
Experience: The biggest banks in the world are extensively involved in funding infrastructure projects. As a result, almost all of them have separate departments that have developed considerable expertise in infrastructure financing. Therefore, when a company executing an infrastructure project applies for a bank loan, they also get to benefit from this expertise. Anyone lending money to the project has an implicit role in monitoring the project in order to protect their own interests. The significant experience and resources in which banks have just make them more suitable to perform this task.
Flexibility: Bank loans can be significantly more flexible as compared to other sources of debt funding. This is one of the major reasons that bank loans are more suitable for infrastructure projects. For instance, infrastructure projects need money in phases. Once they complete a certain milestone, they want more money to be disbursed. Such complicated disbursement schedules can be easily managed by a bank. On the other hand, it is difficult to obtain this flexibility using bonds. In case of a bond issue, the infrastructure company will be forced to collect the proceeds from the sale of bonds all at once. Then, they will be forced to pay interest on the money even though they might not be using the same. If they want to obtain the loan amount in installments, they will have to raise money using different bond issues. Different bond issues will create their own set of complications viz. seniority of debt etc.
Restructuring: Delays, cost overruns, and such other difficulties are commonly experienced while executing infrastructure projects. If such a problem arises during a project, the infrastructure company would be glad to have taken bank loans instead of having issued bonds. This is because delays in the execution of the project also delay the cash flows to be received from the project. As a result, the repayment schedule has to be changed. Sometimes the loans become riskier as the infrastructure company may require a higher moratorium period. In such cases, if the infrastructure company is negotiation with a bank, they will find it easier to restructure the loan. This is because the bank is just one party, and their interests are completely aligned with that of the project equity holders. They are unlikely to receive any benefit from stalling the project.
On the other hand, if any sort of negotiations has to be done with bondholders, the process becomes extremely complicated. First of all, there are multiple parties that are included in the negotiation. Then, it is quite possible that these multiple parties have conflicting interests. As a result, when the cash flow structure is modified, all parties may not agree to it. This could create a legal hassle, and the issue could end up reaching court. Also, if the company is unable to pay its bondholders, some of them may file insolvency proceedings against the company and try to send the company into liquidation.
Evidence shows that when it comes to restructuring, banks are much easier to deal with as compared to bondholders.
Risk Profile: Also, it needs to be understood that bonds are mostly purchased by funds such as municipal funds, pension funds, and even insurance companies. The law requires these companies only to buy investments that have very low risk. The problem is that in many parts of the world, infrastructure investments are considered to be risky. Therefore, in these countries, companies do not have the option to issue bonds. Instead, they are forced to take bank loans by default.
Signaling Effect: Lastly, even if a company plans to raise debt using bonds at a later stage, they are better off using bank loans, to begin with. This is because when banks lend money to a project, the other investors who have limited monitoring capacity feel comfortable investing their money in the project. This is because they feel that since banks are involved, they will be monitoring the project. Hence, their money would be safer than it would have been otherwise.
The only disadvantage that banks have is that they are funded using relatively short term liability. Hence, they cannot make really long term loans. To overcome this, banks usually finance the construction stage of a project, whereas once the company starts to create positive cash flow, bonds are generally issued to repay the banks.
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.
Let's 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.
Parties Involved in Infrastructure Debt Issuance
Bonds are commonly issued during infrastructure projects. The company holding the equity stake is generally the one issuing the bonds. This means that the company owning equity is the one actually borrowing money from the bondholders and, therefore, the one owing the money back.
Even though the responsibility of repaying the loan lies with the infrastructure company, it is not the only one involved in the issuance as well as servicing of debt. Infrastructure companies require a full team of specialists to help them in the various tasks required to issue and manage debt instruments.
The different parties which are involved in the process, as well as the role which is played by each party, have been explained in detail in this article.
Lead Arranger: Infrastructure companies usually hire investment banks to play the role of the lead arranger. The role involves taking the lead and being responsible for the underwriting and distribution of the entire debt issue.
Lead arrangers may or may not serve as the underwriter for the infrastructure bonds being issued. In case they do serve as underwriters, they are contractually bound to buy the bonds from the issuer. Usually, underwriters first enter into agreements with investors. Once they have these agreements in place, they use the same to enter into an agreement with the infrastructure company. In reality, they are only acting as an intermediary. The only risk that the bear is that they will be left with the bonds in case any of the parties that they signed the agreement with reneges on their promise.
Trustee: Most infrastructure bonds which are issued involves the use of collateral. It is important to monitor the collateral in order to protect the interests of bondholders. This role is played by the trustees. They are the ones who keep an eye on the collateral and ensure that the underlying assets are not liquidated, thereby harming the interests of the bondholders. In theory, a trustee is supposed to be an independent third party. However, in real life, trustees are appointed by the issuers and hence are more inclined towards them. However, in strictly legal terms, trustees have responsibilities towards the issuer as well as the bondholders.
Paying Agent & Fiscal Agent: Paying agent and fiscal agents are appointed by the issuer in order to track the proceeds which have accrued as a result of the sale of bonds. The difference between the two is that fiscal agents only have responsibilities towards the issuer, whereas a paying agent has responsibilities towards both the parties. These agents are responsible for ensuring that the special purpose entity has enough cash flow to make good its promise of timely periodic interest and principal payments to the bondholders.
Monitoring Advisor: The role of the monitoring advisor is to reduce the technical complexity and appraise the investors of the current financial situations. Infrastructure projects tend to be quite technical. On the other hand, investors have financial expertise and are not well versed with the technical side. Hence, a monitoring agent is appointed to act as a liaison between the two parties.
The role of the monitoring agent is to understand the project from a technical point of view and explain the same in financial terms to the investors. Monitoring advisors are supposed to help special purpose entities comply with financial terms and covenants which have been listed in the bond agreement. Monitoring agents conduct on the ground checks for the investors, which is important in order to safeguard their investments.
Listing Agent: As their name suggests, the job of a listing agent is to help the infrastructure company list their bonds on different exchanges. Each exchange has rules and regulations which need to be complied with in order to allow listing. In larger bond issues, such listing is considered to be very important since it provides secondary market liquidity to the investors. Listing agents have expertise with the rules of stock exchanges and hence can make the listing process much easier.
Attorneys: Both the investors as well as the infrastructure company generally have their own team of lawyers, which help them draw up a contract. Each side tries to include clauses that protect their interests. The final agreement is the result of several rounds of negotiations between both the legal teams. In some cases, the same lawyers represent both the issuers as well as the investors!
Auditors: The services of auditors are required extensively in infrastructure projects. This is because whenever bonds are being issued, the issuer provides certain financials. The accuracy of these financials needs to be verified in order to ascertain the creditworthiness of the project. Similarly, during periodic reviews, the issuer submits the income statement and the balance sheet of the project. This also needs to be verified in order to assure the investors that their investment is being safeguarded.
The bottom line is that bond issuance is actually a complex process that requires several roles to be played. It is not necessary that each role has to be played by a different party. Sometimes the same company can play three or four different roles. However, all these roles also involve costs that make bond issuance an expensive process.
External Credit Enhancement in Infrastructure Financing
Infrastructure projects continue for a long period of time. Sometimes these projects continue for decades. Hence, they need long term finance. On the other hand, there are entities such as insurance companies and pension funds which are looking to invest their money for long periods of time. Ideally, insurance companies and pension funds should be the biggest source of infrastructure financing since their needs are complementary to that of infrastructure companies.
However, in most cases, insurance companies and pension funds are unable to invest their money directly into an infrastructure project. This is because such investments may be risky and since these organizations have a lot of public money, they are required by law to be careful about the riskiness of the investments that they make.
It can therefore be said that the higher risks inherent in an infrastructure project prevent it from getting finance. Therefore, if there was a way to somehow de-risk the cash flows, it would open a new avenue for infrastructure companies which would help them raise funds much faster and at a lower cost.
The mechanism of de-risking the cash flows is called credit enhancement. Credit enhancement can be done either internally or by external parties. In this article, we will understand what external credit enhancement is and what the various methods of implementing external credit enhancement are.
The Anatomy of External Credit Enhancement
External credit enhancement is a mechanism of involving a third party with a stronger credit profile than the issuer in the finances of the infrastructure project. The basic idea is that all the responsibilities of repaying the debt related to the project will still remain with the infrastructure company itself. However, in the event of a crisis, its finances will be supported by a different party with a much stronger credit profile. Since external credit enhancement is a kind of guarantee, it can only be provided by organizations which have good financial strength such as banks, insurance companies and governments.
Also, for credit enhancement to be effective, it is important that too many terms and conditions are not built into the contract. This means that in a crisis situation, the infrastructure company must be able to drawdown the finances from the guarantor with relative ease.
The funds provided by external credit guarantors are generally provided after some sort of a trigger. However, it is important that these funds are provided proactively i.e. to prevent a default rather than reactively after a default has already taken place. The timeliness of the external credit guarantee is one of the most important factor which helps de-risk the cash flows and make them more palatable to institutional investors.
Methods of External Credit Enhancement:
The different methods of external credit guarantees commonly used by infrastructure finance companies have been listed below:
Bank Guarantees: In many infrastructure projects, a syndicate of banks is the main financier. Sometimes, infrastructure companies will ask one of these banks to guarantee their cash flows in return for a fee. For the other creditors, this improves the situation drastically. This is because they no longer have to rely on the cash flow generating potential of the underlying infrastructure company. Instead, they can rely on the cash flow generating potential of a stronger institution such as a bank. However, banks will only agree to offer a guarantee if they are provided some control over the process. In most cases banks want the authority to constantly monitor the project as well as the books of the company before they give out a bank guarantee.
Monoline Insurance: There are many insurance companies which specialize in providing insurance to external debt holders. This means that these insurance companies accept a premium and promise to make good the investor's loss in the event of a default. Many infrastructure companies pay the premiums of behalf of their investors. By doing so, the company makes its own credit profile irrelevant in the short run as investors are directly dealing with the insurance company.
Mezzanine Finance: Mezzanine debt is another mechanism which can be used to enhance the credit of the infrastructure project. Mezzanine debt lies between senior debt and equity loans. If the company does not face a cash flow squeeze, mezzanine debt continues to exist as a high yield debt instrument. On the other hand, if the company does face a cash flow squeeze, the debt may be converted to equity. Since it poses no risk to senior creditors, it allows companies to sell senior bonds at considerably low rates of interest.
Supplemental Income: In some cases cash flow from other projects is bundled along with the cash flow from the underlying project. The certainty of the cash flow of another project reduces the inherent riskiness of depending upon the cash flow from one project. This is similar to the concept of over collateralization in bond issuance. It reduces the risk for prospective investors and as a result reduces the interest rate which needs to paid out in order to avail the funds.
To sum it up, there are many ways of enhancing the credit profile of the infrastructure bonds in order to make it more palatable to institutional investors.
Revenue Bonds and the Cash Trap Mechanism
Infrastructure projects last for many years. As a result, different sources of funding are used at different points of time in the project. As mentioned in the previous articles, most of the time, bank loans are used during the construction phase of the project. However, at the same time, bonds are the preferred source of debt funding after the project has become operational.
A special type of bond called a revenue bond is commonly used in order to fund infrastructure projects. In this article, we will have a closer look at what revenue bonds are and how they function.
What are Revenue Bonds?
Revenue bonds are debt instruments that are commonly floated by infrastructure companies. Their name is derived from the fact that these bonds are secured by the revenues of an income-producing project. It needs to be understood that since revenue bonds are almost exclusively issued by government entities, there is a misconception that these bonds are secured by the government. The reality is that in most cases, the bondholders only have a right to the cash flows of the project or the portfolio of projects for which bonds have been issued. In the event of a default, people holding revenue bonds will not be able to ask the government to make good their loss.
This is the major difference between government debt and revenue bonds. Government debt is secured by the tax revenue generated by the government. On the other hand, revenue bonds are secured only by the cash flow, which will be created by the infrastructure project being securitized. Since the risk profiles of both bonds are different, the yields provided by both bonds are also quite different. Government debt symbolizes almost risk-free investments. Hence, their interest rates are also quite low. On the other hand, revenue bonds may be quite risky, and hence, sometimes, their yield can be quite close to the ones which are provided by private companies.
How Do Revenue Bonds work?
The cash flows being controlled by revenue bonds are not managed by the government or the special purpose entity which has been created to manage the infrastructure project. Instead, a special trust is set up to act as a neutral party and balance the interests of the bondholders as well as the shareholders. This trust oversees the cash flow, which has been generated by the project as well as how the cash is being disbursed.
The trust governing the revenue bonds has clear guidelines about how the cash flows of the project need to be prioritized. This is often referred to as a cash flow waterfall. This is because cash flows to the top levels, and only when the levels are full does the cash flow downstream. A typical cash flow waterfall would first fund the operating and maintenance expenses required to keep the project in good shape so that the revenue stream continues. In many cases, capital expenditure is given second priority. Then the leftover money is used to service the outstanding debt. Once that task has been completed, the leftover money is used to fill up reserves and surpluses. Only after all these payments and appropriations have been done can the equity investors distribute any money amongst themselves.
Revenue bonds work like private companies. This means that the debt service coverage ratio becomes a very important number when it comes to revenue bonds. The covenant which governs the bond prescribes a minimum debt service ratio that needs to be maintained. This ensures that too many bonds are not issued while the cash flow backing the bonds may not be too little.
In the case of revenue bonds, generally, there are clear and well-defined guidelines regarding the debt coverage ratio. There are restrictions regarding the historical debt service ratio, which has been maintained as well as the projected debt service ratio, which may have to be maintained in the future. Generally, a debt service ratio of 1 can be considered to be adequate. However, most revenue bonds prescribe the maintenance of a ratio of anywhere between 1.3 to 1.7. The extra money acts as a cushion and protects the bondholders from unforeseen events. The process of creating these extra reserves, which can be kept as a rainy day fund, is called the “cash trap” mechanism.
The extra money is kept as a reserve. In the future, if the cash flows from the project are not sufficient to meet the obligatory debt payments, money can be taken from these reserve accounts. The drawdown of the reserve accounts is considered to be a proactive step, which means that it prevents default. However, the act of withdrawing money from a reserve account could itself constitute a default since it means that the cash flows generated by the project were not enough to cover the debt service payments.
If there is no drawdown from the reserve fund for a stipulated number of years, this fund can then be used to retire the senior-most debt. Once the debt is retired, the amount requires to service the debt reduces. As a result, it becomes easier to maintain the debt service coverage ratio.
To sum it up, the revenue bond is a financial tool that has been created specifically for the purpose of funding the operational phase of infrastructure projects. Hence, it has many features that are useful for infrastructure companies.