EU project bonds are not guaranteed A-rating

Plans by the European Commission (EC) and the European Investment Bank (EIB) to move private sector infrastructure bonds out of the lower echelons of the investment grade category (BBB) are positive, but are not guaranteed success, writes rating agency Fitch in a report.

“Fitch Ratings considers that the proposed mechanism would improve a transaction’s credit risk. Whether or not such benefits will justify a credit rating in the ‘A’ category – stated as a key objective – is more difficult to assess at this stage,” the rating agency says.

This is because individual projects’ characteristics may undermine the EC/EIB’s proposed credit-enhancing mechanisms and prevent bonds from gaining the much-coveted A rating that would, in theory, open the door for larger numbers of institutional investors to buy infrastructure debt.

The Europe 2020 Project Bond initiative, as the EC/EIB plan is known, proposes to enhance a bond’s credit rating by providing either a fully funded subordinated debt tranche or an unfunded subordinated debt guarantee. Both mechanisms can cover up to 20 percent of a project’s senior debt. Subordinated debt ranks below senior debt and above equity.

Fitch admits that both funded and unfunded subordinated tranches “may support a rating uplift” but notes that “it is often the case that rating levels are not primarily dictated by quantitative measures of credit risk, be it leverage or coverage metrics, but by other aspects that may be purely qualitative”.

Some of the factors weighing on ratings include grantor risk (“If a grantor in an availability-based PPP [public-private partnership] is rated ‘BBB’, it is very unlikely that the debt rating will be higher,” Fitch points out), construction risk, ramp-up risk, operational risk, and sovereign risk. 

For bond ratings to move from the BBB category – where “most EMEA [Europe and Middle East] projects fall into” – to the “fundamentally stronger ‘A’ category […] both strong qualitative characteristics and materially improved metrics would be required,” Fitch states. 

This means that a project bond for a PPP with fairly secure cash revenues (like an availability-based PPP) that is offset by high leverage and operated by a financially weak counterparty would not be guaranteed an A rating, Fitch suggests.

The Europe 2020 Project Bond initiative is currently undergoing public consultation. It is not expected to be operational before 2014.