How project finance debt performs

If last year was anything to go by, 2013 will be a record year for infrastructure debt fundraisings.

By now, the following figure has already been referred to quite frequently, but it’s worth highlighting it again because it illustrates clearly the surge of interest in the nascent asset class: out of the $23.5 billion raised by infrastructure funds last year, 12 percent corresponded to infrastructure debt fundraisings.

This makes the second edition of ratings agency Moody’s study on the default and recovery performance of project finance loans a timely affair. Those wondering how project finance debt has behaved historically will appreciate Moody’s insights, especially if they are considering taking the plunge into the asset class.

The basics

Before we start, a word about the study. Moody’s data covers 4,067 projects accounting for 53.6 percent of all project finance transactions that took place between January 1, 1983 and December 31, 2011 – a 28-year period.

Moody’s defines project finance as “the financing of long-term infrastructure, industrial or public services using limited recourse long-term debt raised by an enterprise operating in a focused line of business in accordance with contractual agreements”. Industries covered by Moody’s project finance definition include infrastructure, media and telecoms, oil and gas, as well as power, among others.

Using the Basel II definition of loan default, the ratings agency tracks the performance of project finance loans over that 28-year period. Of the 4,067 projects it analysed, only 302 defaulted, leading Moody’s to deem project finance “a resilient class of specialised corporate lending”.

With that encouraging description in mind, let’s take a look at how project finance debt behaves.

If you take a look at the cumulative default rates chart, you will find that, over a 10-year period, the default rate of project finance debt is pretty much in line with the default rate of low investment grade/high speculative grade corporate credit – that is, corporate bonds and loan issuers rated in the Baa and Ba categories.

That’s not entirely surprising and it’s widely known that project finance/infrastructure projects, especially if they have an element of construction risk, tend to fit in the low investment grade bracket.

Where it gets interesting is when you take a look at marginal default rates, which Moody’s says “reflects the likelihood that a performing loan at the start of a specific year defaults in that year”.

Using that metric, marginal annual default rates for project finance loans average 1.7 percent per year during the first three years after financial close – which Moody’s calls “initially consistent with marginal default rates exhibited by high speculative grade credits”.

However, once project finance debt moves beyond that three-year period, which “is strongly linked to construction-phase risk”, marginal default rates fall sharply and start “trending towards marginal default rates consistent with single-A category ratings by year 10 from financial close,” the ratings agency points out.

The good news is that when disaster does strike, recovery rates for project finance debt are remarkably good. Put simply, these rates for project finance bank loans average around 80 percent, but the most common recovery rate is 100 percent. This means that when there is a default, two-thirds of the time it causes no economic loss to the lenders.

Encouragingly, ultimate recovery rates are also substantially independent of the economic cycle at the time a default occurs. Whether a default occurs in 2000 or 2009 doesn’t seem to affect ultimate recovery rates.

Another interesting feature of project finance debt – when compared with corporate debt – is that a spiral of defaults, as occurred during the US power crisis in the early 2000s, does not depress recovery rates, whereas a spike in the number of corporate defaults at a given time translates into lower ultimate recovery rates, Moody’s explains.

Ultimate recovery rates are also refreshingly uncorrelated with a country’s level of economic development.

The Moody’s data shows that whether a country is a member of the Organisation for Economic Co-operation and Development (OECD) or not doesn’t seem to have an appreciable impact on recovery rates. Both OECD and non-OECD countries have recovery rates hovering around 80 percent.

There is a notable difference between ultimate recovery rates for projects that default during construction – which have an average recovery rate of 65.1 percent – as opposed to those defaulting during the operational phase – where the recovery rate is 83.2 percent. According to Moody’s, most projects tend to default around the three-year mark.

In the end, ultimate recovery rates for project finance debt are comparable with the ultimate recovery rates for senior secured corporate bank loans. Senior secured corporate bank loans that defaulted between 1987 and 2011 averaged an ultimate recovery rate of 80.3 percent – the exact same recovery rate for project finance loans that defaulted during the same time period.

The ultimate recovery rate for all types of corporate bank loans stands at a much lower 68.4 percent.

But even though recovery rates are similar between project finance and senior secured corporate bank loans, project finance debt is “substantially uncorrelated” with the legal jurisdiction of the defaulted company, overall default rates, and the presence of subordinate debt in the debt structure – three factors which significantly impact recovery rates in the corporate debt sector.