It was a classical case of contagion. The ‘wrapped’ infrastructure bond – for years a successful product that insured and credit-enhanced project finance bonds – did not survive the implosion of the monoline insurers – even though it was a perfectly sound product in its own right.
How could it? After all, the whole concept of insurance depends on the creditworthiness of the insurers and investors’ trust that these firms are equipped to deal with the risks they shoulder.
When the monolines went from insuring municipal and project finance debt to insuring complex ‘CDOs of CDOs’ [collateralised debt obligations] in the mortgage sector – and when the latter then spectacularly blew up in their faces, dragging down their investment grade ratings and leaving investors with portfolios of sub-investment grade bonds on their books – investors became understandably wary about the soundness of the monolines’ judgement.
This must have been especially frustrating for Assured Guaranty, which had made a conscious decision not to venture into the complex world of mortgage derivatives. Because even though its products were mostly sound and its credit rating was a healthy AA, it was still part of what was essentially a defunct industry.
Dominic Nathan, Assured Guaranty’s European head, knows this only too well and readily admits that one of the reasons why Assured Guaranty took so long to return to the infrastructure market is because it needed to convince investors of its essential soundness.
“I think there certainly was an element of the passage of time,” Nathan begins. “The [monoline] model was undermined because of the ratings fall in our peer group, which caused the industry to take a step back and go: ‘Whoa, this whole industry has a problem’.
He continues: “So we constantly had to tell people: ‘Look, we know that you are concerned about what happened to our competitors, but they went into lines of business we chose not to, for credit reasons. We are still financially very strong and an AA category rated company.’ But in the beginning investors would say: ‘Well, great, but how do we know that’s not going to happen to you guys?’ So there has been an element of the healing process involved.”
The UK’s Worcestershire Hospital, Assured Guaranty’s comeback deal, was thus the result of a long, three-year period that saw the monoline engage with investors to convince them of the company’s continued strength and its willingness to re-engage with the infrastructure space. Those talks, and a little quid pro quo with investors, effectively sealed the deal on Assured Guaranty’s return to infrastructure.
“Part of the feedback we were getting from investors is that they have these portfolios of wrapped infrastructure bonds, many of them wrapped by our peer group, which is no longer investment grade, and those are not ideal assets for them, because they are unrated and they are getting no information on the underlying projects. So they asked us to help them fix this problem before they would start buying new bonds for primary deals,” Nathan explains.
The year-in-the-making Worcestershire re-wrap was elected as the pilot project and, after long negotiations and ironing out the legal details, Assured Guaranty replaced fellow monoline Ambac as guarantor for a £97.2 million (€117 million; $154 million) bond maturing in 2030.
The bond was raised in 1999 to help fund the construction and operation of the hospital. Assured Guaranty will get paid for the replacement via a reduction in the bond’s coupon, a decision backed by over 90 percent of the bondholders.
As well as serving as a conduit to getting investors to commit money to new principal wraps, replacement deals offer Assured Guaranty a steady – and lucrative – pipeline of deals going forward.
“We see replacements as an important but finite line of business, so we hope to execute them over the next three of four years given that we and the market can’t do it all at once. Also, we’re never going to do all the potential replacements – we have to find the right investors and the right deals. These replacements will be an important business source for us whilst we build our primary line. Twelve months from now we expect that the majority of our business will be in relation to new deals,” Nathan explains.
The opportunity is certainly attractive. After all, as Nathan contends, the amount of capital an insurance company has to set aside under Solvency II regulations for a BBB bond is quite a bit larger than for an AA-rated bond. But, given that Assured Guaranty is currently looking to corner the replacement market and start wrapping new deals, just how many infrastructure bonds is the monoline able to wrap?
“Our capacity constraint is really on a per deal basis,” muses Nathan. “On a replacement deal like Worcestershire, we can probably do up to £500 million per deal – which incorporates most of the market, but not all of it. On new deals, it’s probably slightly less, maybe up to £350 million. That’s the constraint on a deal basis – we don't expect to be constrained by country or sector limits,” he adds.
Yes, but conceivably there will be some sort of limit to how many infrastructure deals Assured Guaranty will be able to do?
“To put it into perspective, we have nearly $600 billion of net par outstanding on transactions that we have insured – most of it being US municipal bonds. We already have some $18 billion of European infrastructure on our books. It’s a big balance sheet. There are formal limits for us but currently we have more capacity than there are [infrastructure] deals to insure,” Nathan says, before adding: “It’s still a challenging market. It’s not like we’re going to do 10 deals over the next few weeks.”
When it comes to geographies, Nathan highlights that “the UK remains our biggest European market, so we’re very focused on it” and points out that, “even though a lot of changes are going on, there are still a lot of deals in the pipeline, including three reasonably large hospital PFIs [Project Finance Initiative] we are watching, since hospitals are a big part of what we did in the past”. But Assured Guaranty is keeping its eye on other European markets, including Scotland, France and Germany. In addition, the monoline also has infrastructure teams in New York and Sydney pursuing opportunities in the Americas and Australasia.
PIECE OF THE DEBT PUZZLE
It’s obvious from the above that Assured Guaranty has devised a clear plan to return to the business of insuring infrastructure debt. But where does the company fit in a world of debt funds, European Investment Bank (EIB) project bonds, and government initiatives – like the UK’s – to get pension funds to invest directly in infrastructure debt and equity? Or put differently: What will be the monoline’s role in a world that is seeing banks increasingly retreat from the mainstream of project finance?
“I see our role as an important part – but only a part – of the overall debt solution,” stresses Nathan. “What I don’t see is just one weighty solution going forward, as the monolines were in the pre-crisis era. I just don’t see one idea big enough to do what’s required,” he argues.
“The way I see it is a number of solutions running alongside each other and providing capacity to the market. So, I think you’ll see Assured Guaranty wrap bonds, I hope Hadrian’s Wall [one of the first infrastructure debt funds] is successful and the EIB is successful. I think you’ll see all of these solutions coming along and competing on a deal basis. I see a world of four or five competing, but different, solutions that will be the facilitators of the capital markets, rather than just one.”
However, it’s clear Nathan believes in the competitive advantages of the monoline wrap, a product investors already know well.
He’s especially keen to underline that “where investors see our value, especially financial sponsors, is in the controlling creditor role we have. I think there are a lot of other solutions that sound very good until you get to the point of the controlling creditor and then you need to have someone incentivised to think the same way as bondholders, who have capital at risk. Because without that, arguably bondholders aren’t as safe,” Nathan argues.
“So we’re seeing that [demand] from all sides and to have us as controlling creditor with skin in the game is incredibly important,” he concludes.