Improving Ratings: Forms of credit enhancement for bond issuers

Forms of credit enhancement for bond issuers

Credit enhancement is a method by which a borrower or a bond issuer attempts to improve his debt or creditworthiness. The concept of credit enhancement is widely prevalent in developed countries and is ideally suited to companies which have strong underlying potential but the balance sheet, profit and loss account and current cash flow are weak, thus restricting the ability of the enterprise to raise the required funds. Various forms of credit enhancement are available today and these need to be promoted further in order to strengthen the rating of corporate bonds in the country.

Partial credit enhancement

A partial credit enhancement (PCE) is an unconditional and irrevocable partial guarantee with a first loss default guarantee (FLDG) in most cases. Therefore, anything less than a 100 per cent guarantee is a PCE. The PCE scheme was first launched by India Infrastructure Finance Company Limited in 2012, followed by the roll-out of a credit enhancement scheme by the Power Finance Corporation in 2013. The Reserve Bank of India (RBI) also issued guidelines in 2015 and again in 2016 for PCE to corporate bonds.

A partial guarantee can be in the form of either an FLDG or a proportional guarantee, based on which the credit rating is affected. Other factors such as an amortising/non-amortising guarantee, guarantee structure and payment mechanism also influence the rating enhancement. Legal enforceability varies across instruments. The PCE mechanism involves rating the underlying debt with respect to its credit quality, the guarantor’s credit quality and the correlation between the cash flows of the guarantor and issuer. Further, in a PCE mechanism, credit rating agencies are heavily involved.

Rating approaches differ based on the specific circumstances of the issuer and the industry. However, broadly the approaches followed are the following – the probability of default approach and the project-specific approach. While the former is commonly adopted, credit enhancement at the project level is typically applicable to infrastructure assets. The criteria for project-specific credit enhancement include the presence of a long-term arrangement to ensure revenues, concession agreements with the state or central granting authority to collect revenue (e.g., toll), an escrow account where revenue flows in and from which payments are made to lenders without any leakage, and a track record (past operations of the underlying entity borrowing the funds) which can be tested for stress scenarios.

There are a number of issues with the PCE mechanism due to which it has received a lukewarm response. The incremental cost-benefit analysis is not favourable in most cases; hence, there are limited transactions. According to RBI, after 90 days of devolvement, the PCE facility becomes a non-performing asset (NPA) unless reinstated. This means that if the PCE is invoked, it has to be repaid in 90 days, which does not typically happen in the case of infrastructure projects. Another challenge is that infrastructure companies require long-term cash flows (8-10 years) to determine the PCE. However, investors such as mutual funds and high net worth individuals are willing to take exposures of only three-five years, and therefore the participation of this investor class is limited. Some of the benefits are that the PCE gives the issuer access to a wider pool of resources and grants payment relief to the issuer by giving him the option of deferring the payment to creditors.

Other forms of guarantee

Corporate guarantee: An entity with a strong credit profile and rating gives an unconditional and irrevocable guarantee for the entire debt to be rated. The guarantor is usually a parent company or a flagship company (in the case of conglomerate groups). The guarantee needs to be in place for the entire tenure of the loan. The rating is the same as that of the stronger entity, along with the suffix of SO (structured obligation).

Limited corporate guarantee: An entity with a stronger credit profile and rating gives an unconditional and irrevocable guarantee for a partial period or partial amount. A limited corporate guarantee is usually given for greenfield projects, covering the period of construction and stabilisation (including overruns, if any). Sometimes, the guarantee is for a fixed part of the assessed value which is at risk. The rating reflects the credit quality post stabilisation (maximum up to the guarantor’s rating) along with the SO suffix. The guarantee is released, say, one or two years after the commercial operation date. This form of guarantee is common in the road and renewables sectors in which a number of greenfield projects are coming up. A limited corporate guarantee is based on factors such as the guarantor’s credit profile, debt service coverage ratio and other leverage ratios.

Letter of comfort (LoC): It is a written document providing a level of assurance that an obligation will ultimately be met. The issuer, the borrower, the relationship between the two and the language of the LoC influence rating views. An LoC is usually given by a parent company on behalf of a subsidiary which needs to borrow. It can also be issued by the state or central governments for government undertakings. Ratings may be the same as those of the provider of the LoC or a notch lower with the SO suffix. Key examples are LoCs issued by the Ministry of Railways to Konkan Railway Corporation Limited for making funds available to the company, if required; and LoCs issued by parent company International Paper Company, USA, to International Paper APPM Limited (formerly known as Andhra Pradesh Paper Mills Limited) for stabilising the company’s financial arrangements. Globally, LoCs are strong trade transactions, however, in India, they are not being used.

Structured payment mechanism: This is commonly used in infrastructure projects. Some features of the mechanism are a waterfall structure for cash flows, cash-trap mechanism (triggered if certain covenants or ratios are not maintained), certainty of cash flows due to annuity-based or fixed tariff revenues), controlled revenue and cost items, and minimum counterparty risk. For structured payment mechanisms, an escrow arrangement and debt service reserve account (DSRA) are critical components. The upfront creation of a DSRA ensures repayment for a stipulated period in case of a shortfall. It is the promoter or sponsor’s guarantee till the project completion stage or fulfilment of certain financial covenants.

Multi-tiered structure: In this kind of structure, debt is classified in tranches – senior and subordinated, Class A, B, and so on. Cash flows generated by assets are allocated with different priorities to classes of varying seniorities. Subordinated tranches function as protective layers of the more senior tranches. The tranche with the highest seniority has the first right on cash flow. These structures are characterised by well-defined payment waterfall mechanisms. The subordinated debt rating may be recommended at one or more notches lower than the senior debt rating owing to the former’s weaker security features including a lower ranking in the payment waterfall or a lower debt service coverage. Both debts may be rated the same if the structure prescribes similar events of default, equal importance in the payment waterfall or similar debt coverage conditions. A multi-tiered structure has the following features – a tight escrow mechanism, lender protection features such as cash trap/cash sweep mechanism, usually fixed rate debt, creation of DSRA as a buffer for repayment and contingency reserve, and separate repayment schedules for senior and subordinated tranches.

Conclusion

The government, realising the need to deepen the bond market, has announced a credit enhancement fund, the guidelines for which are expected to come out soon. The fund, by providing partial guarantees on bonds of infrastructure projects, will increase the attractiveness of such project bonds for institutional investors. It will also improve the cash flow stabilisation of infrastructure projects, due to which the cost of credit for such projects will come down. However, for the credit enhancement fund to succeed in the country, there must be an equal focus on project selection, efficient conflict resolution mechanisms and appropriate capital structures.

Based on a presentation by Sanjay Kumar Agarwal, Senior Director, Care Ratings Limited, at a recent India Infrastructure conference