Making CEFs fly

Highest rating, substantial scale, and bespoke regulations are essential to make the soon-to-be launched Credit Enhancement Funds work

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The Credit Enhancement Fund (CEF) being launched by the government next month to boost bond market funding for infrastructure projects will need facilitations on three fronts if it has to fly.

CEF is of great significance because protracted asset quality nightmare and tightening regulations have eroded banks’ ability to fund infrastructure projects. In the past three years, outstanding bank credit to infrastructure has fallen 300 basis points to 12 per cent of the bank book.

Crisil’s analysis shows that in the next three years, India requires over ~30 trillion to build roads, railways, airports and meet growing electricity requirements. At the current pace of bank funding — maintaining which will take a herculean effort — there will still be a financial gap of ~7-8 trillion.

And that’s where the corporate bond market has to pitch in. However, bond investors such as insurers and pension funds are credit-risk averse and prevented by regulations and/or internal investment policies from investing in issuances rated less than AA category. Infrastructure projects, even after commissioning, are rated way lower in the initial years.

This is where the CEF can help. By providing guarantees to long-term bonds issued by infrastructure entities with a credit rating lower than AA category, the fund can attract ‘patient’ capital.

The commercial viability of CEF stems from the fact that credit profiles of infrastructure projects improve once commissioned. But it will also require three facilitations to kick-off.

One, since prospective investors, mainly insurers and pension funds, have an AA category rating floor, the viability of CEF hinges on it achieving the highest rating of AAA. Anything less will simply not do.

What will that require? Minimising business, financial and managerial risks in operations. This can be done through high initial capitalisation, a conservative leverage ratio in the early years, strong parentage along with an independent, experienced management, and a robust credit appraisal and evaluation mechanism.

Two, the fund should achieve significant size and scale of operations soon enough to ensure three things: Impact, commercial viability, and adequate return on equity. The quality of management, highly experienced in credit appraisal of infrastructure projects, with the highest standards of corporate governance, and a very strong commercial orientation would be quintessential.

Three, the CEF will need bespoke regulations. Current ones for banks and non-banks won’t suffice for an entity in the business of providing guarantees. So customised adaptations of regulations on stressed assets recognition, provisioning and capital adequacy, aligned with the credit guarantee business, will need to be penned.

But globally, there are learnings that can be emulated.

Take for instance, the Credit Guarantee and Investment Facility (CGIF), established in 2010 with a corpus of $700 million by 10 members of the ASEAN, China, Japan, South Korea and the Asian Development Bank to provide guarantees on local currency bonds issued by corporations in the region.

As of 2017, CGIF had issued 19 such guarantees worth $1.1 billion to 14 companies in local currency bond markets. The corporates receiving its guarantees engage segments like renewable energy, healthcare, and oil & gas.

Notably, CGIF is rated AA on a global scale by S&P Global, and AAA on the Indonesian national scale by Fitch Ratings Indonesia, driven by its conservative leverage, prudent investment strategy and a steady build-up of its track record in the bond guarantee segment.

Another example is GuarantCo, a specialty insurance company established in 2006 by government developmental agencies of the UK, Netherlands, Sweden and Switzerland. GuarantCo provides credit enhancements to project bond issuances in Africa, Asia, and Latin /Central America. Since inception, GuarantCo has committed $886 million in guarantees to infrastructure projects, and significantly increased its equity to over $1 billion today. GuarantCo is rated AA on the global scale by Fitch, given its robust credit evaluation, monitoring framework and sustained capital infusion by sponsors, keeping it sufficiently capitalised.

Then there is the Danajamin Nasional Berhad (DNB), set up by Malaysia in 2009, with a corpus of $250 million. DNB has issued guarantees worth $1.35 billion to Malaysian corporates across transport and real estate sectors.

The guarantee issued by DNB, in the form of a credit enhancement, upgrades the borrower’s credit rating to ‘AAA’, given the strong financial support DNB gets from the government, besides its robust capitalisation, strong liquidity, and conservative leverage.

The three enablers, and the global learnings can go a long way in facilitating funding of India’s infrastructure.