Zhang Boyuan/Dagong Credit
Abstract: As an innovative kind of bonds, project revenue bonds have distinctive features from the general corporate bonds. With the regulatory policy becoming gradually clear, the bond issue has expedited, and projects tend to stay in the main public utilities category. Based on the statistical analysis of project revenue bonds issued in the current bond market and relevant policies, this paper summarized the main motivations for the issue of the bonds. Furthermore, the paper explores main credit risk factors of them.
Key words: Project Revenue Bonds, Issue Characteristics, Credit Risk
Project revenue bonds, are issued by the project implementation side or its actual controller, and used for the investment and construction of certain projects. The operating income will be the main principal and interest which is used for bonds redeemed. In China, project revenue bonds are innovative products that operate in the same way as US municipal income bonds. Project revenue bonds in China include two kinds; one is project revenue bond, supervised by National Development and Reform Commission (“ NDRC”), and the other one is project revenue paper, which is supervised by National Association of Financial Market Institutional Investors (“NAFMII”).
Background and Characteristics of Project Revenue Bonds
Emergence of the project revenue bonds is due to the "Opinions on Strengthening the Administration of Local Government Debt" ( NDRC Document No. 43, hereinafter referred to as "No. 43") issued by the State Council in October 2014. No. 43 separated government financing functions from financing platform. Local governments’ financing activities need new alternative products. Therefore, project revenue bonds came into being and replaced city investment bonds, which had been a means for local government’s financing.
Compared with the general corporate bonds, the project revenue bonds have four main characteristics: First, issuer. The issuer of the general corporate bonds is the large enterprise, because the regulator usually has requirements of the issuer in terms of the time of its establishment, asset size and profits. The issuer of project revenue bonds can be the newly established project company, in order to achieve the isolation between independent project operation and capital. Second, transaction structure. The project revenue bonds need to set up a reasonable transaction structure to separate the project and capitalthrough the special account, but the trading structure of general corporate bonds are relatively simple. Third, measures to improve credit. The project revenue bond requires a different compensation mechanism, the project revenue paper has no mandatory requirements; and most of general corporate bonds have no increasing credit measures. Fourth, the source of repayment. The proceeds of project revenue bonds mainly come from the operating income when a project is completed, and the degree of dependence of equity capital of the enterprise is low.
The Issue of Project Revenue Bonds
1. The policy is getting clearer, and issue speed is faster
On July 11, 2014, NAFMII issued the Guidelines for the Business Receipts of Non-financial Enterprises in the Project Income Notes (hereinafter referred to as the "Guidelines"), and officially launched the Project Income Notes (PRN).On July 15, 2014, non-public directional debt financing tool (project income notes) (14 Zheng Dikun PRN001A and 14 Zheng Dikun PRN001B) was the first single project income note which was issued by Zhengzhou Transaction and Investment DiKun Industrial Co., Ltd. On October 30, NDRC formally gave an approval to the project revenue bond of waste incineration power generation project ofthe fourth resource thermal power plant in Guangzhou (14 Sui Thermoelectric Debt), "14 Sui Thermoelectric Debt" as a pilot project was successfully issued in November 18, 2014. NDRC issued the " Project Revenue Bonds Management Interim Measures" (hereinafter referred to as "Interim Measures") in July 29, 2015, in order to make more detailed rules to manage project revenue bonds. Thus, the policy of project revenue bonds has been basically clear.
As is shown in Figure 1, since the Interim Measures was publicized issue proceedings of the project revenue bonds have been significantly accelerated. Since 2016, the issue number has been increasing sharply. There have been 66 items of project revenue bonds issued successfully till the end of 2016, in which project revenue bonds accounted for 49 volumes, and 17 project revenue papers. Since 2016, the number of project revenue bonds was more than 50 volumes, far more than the volumes combined in 2014 and 2015.
2. The distribution of the project is based on public utilities industry
At present, the project revenue bonds issued were mainly based on shantytowns, water industry, transportation and other public utilities industry, with large proportion in shantytowns projects. At the end of 2016, among the total 49 project revenue bonds, 42.86% of them are shantytowns projects.
There are two main reasons for the distribution of the industry: First is the policy, NDRPC's Interim Measures of Administration clearly pointed that the project revenue bonds should mainly give support to infrastructure and public utilities projects that were franchised, as well as other projects which conducive to structural adjustment, people's livelihood and public products and services. Second is the quality of the project. Shantytowns, transportation and water industry have high market barriers, strong regional monopoly, and stable supply and demand structure. In addition, public utilities projects are bearing on national economy and the people’s livelihood with strong anti-cyclical capability, therefore it has stable cash flow in the future.
Key Motivation of Debtor to Issue Project Revenue Bonds
Project Revenue Bonds are the effective financing instruments in PPP Mode
Since the government implemented the PPP model since 2014, issuers and financial institutions have carried out active exploration. PPP model can reduce the investment pressure of the City Infrastructure Investment Corporation in infrastructure projects, but it is not easy to implement it. The most effective method to implement the PPP Model is to establish a joint venture company. PPP project is guaranteed through defining the rights and responsibilities according to shareholding ratio. However, due to the lack of assets, financing capacity issue of the newly joint venture company still remains unsolved. At moment, Project Revenue Bonds provide the most effective solution to resolve this predicament. PPP projects are designed to attract social capital based on the profit projects led by the government. This profitability protects the project's internal rate of return to meet the issue standard of project revenue bonds. Therefore, project revenue bonds become the best financing channel for the joint venture company of PPP projects. From the real market situation, there have been several project revenue bonds issued by the joint venture company of state-owned and private enterprises.
Attempt New Products, Broaden the Financing Channels
Due to its immaturity in transaction structure design as innovative products, project revenue bonds have not realized its explosive growth. But as to the local government financing platform with it main responsibility of financing, especially under the reform pressure of disconnecting with the local government debt, broadening the financing channels have much significance in its future financing and business development. At the same time, the issuance of innovative products can also enhance its market popularity and recognition. When the project revenue bonds first appeared in market of Ningbo, Sichuan and other provinces, the news have been covered extensively by the media. Increase in popularity brings intangible value for the enterprises.
Credit Risk Characteristics of Project Revenue Bonds
The general route of the project revenue bonds’ debt service is that the project benefit serves as the first repayment source, and the balance compensation party or guarantor (if any) as the second source. The credit risk in the whole transaction structure is mainly reflected in three aspects: whether the project could earn full income (benefit), whether the benefit could offset the repayment, and when the cash flow cannot fully cover the principal and interest, whether there is other external source that could guarantee the repayment.
The Risk of Project Construction and Operational
As the first source of repayment, the project operating income (benefit) is the basis and premise of the project revenue bonds’ repayment source. The risks consist of two aspects: construction sustainability and operation sustainability.
In terms of construction sustainability, the first is the risk in construction condition, including the geological conditions and climate conditions of the projects sites, which could have some impact on the implementation of the projects.. The following risk is on engineering technical, project contractor’s qualification and the technical strength will have a large impact on the time and quality of the project construction Finally, it’s the risk of project over-expenditure, once the project cost exceeds the budget, whether the capital and financing capacity of the implementer of the project could support the project investment is also a key factor to ensure the sustainability of project construction.
The main risks of the operation sustainability include the project's operating environment, market demand as well as the operation and maintenance. The operating environment refers to the stability of political and legal environment, and the possibility of not supporting relevant industrial policies issued during the operation period. As to market demand, more attention should be paid to the project's consumption radius and scale, as well as the competition situation and advantage of the market. Operation and maintenance risk is mainly reflected on the relevant industry management experience of the main staff to protect the basic operation and maintenance of the project.
Capital mixing risk
NDRC and NAFMII have different constraints to capital mixing risk. NDRC requires project revenue bonds must "set up the special accounts of financing capital, debt repayment capital and project income collection, in order to isolate risks". NAFMII only requires the setting up of “reasonable transaction structure”. Accordingly, the risk of capital mixing is not common in the NDRC, but it is one of the most common risk factors for project revenue paper. Most of the project revenue paper do not completely separate the operating income of the total project assets (mixing risk 1), or separate the cash flow generated from the project when it gets transferred to the solvency account (mixing risk 2). All of those conditions will lead mixing risk of internal funds confusion and shareholder occupation. In addition, for more flexible use of funds, the issuer tends to finance the projects with bank loans and project revenue bonds. If the issuer does not determine the priority and ratio when paying the principal and interest of bank loans and project revenue bonds with operating income, there will also be capital mixing risk.
Therefore, for the project revenue bonds, which have capital mixing risk caused by incompletely closed transaction structure, the market should determine the future project operating income in the proportion of the compensation source based on the principle of prudence, and assess the risk of internal funds confusion and shareholders’ capital occupation.
The risk of insufficient cash flow
According to the "Interim Measures", the source of repayment of project revenue bonds should mainly derive from the operating income, which is received when the project is completed. At the same time, the project income could include financial subsidies (no more than 50%). If the project cash flow cannot cover the principal and interest, it will give rise to repayment risk. Because the project does not operate when the project revenue bonds are issued, investors and intermediaries could only predict the possibility of cash flow underwriting risk in the future project operation, which will further increase the uncertainty of repayment of the principal and interest with the future cash flow.
NDRC strictly requires that project revenue bonds should set the mechanism of the difference compensation as a second source of repayment. The compensation mechanism can avoid the risk of default when the cash flow is insufficient to fully repay the principal and interest. However, it cannot completely resolve the credit risk of the bond. The difference compensation could solve the current financing pressure, but it cannot solve the risk for the whole duration. When the cash flow shortage problem occurs during operating period of the project, it means that there are two problems: First, the early measurement of cash flow is too optimistic; cash flow shortage will recur during the bond duration in the next few years. This means that in terms of the future bond principal and interest payment, there is a huge capital shortage. Second, the realization of the project cash flow is also related to whether the project could support the operating costs in order to protect future earnings, although the difference compensation is obligated to protect the debt repayment, it excludes to protect the project operation. Cash flow shortage in the early period will make the future operation more difficult, and the income cannot be guaranteed.
Because the project revenue bonds were introduced just two years ago, there is no risk event of difficult project operation that could be used as research sample. In the future, with the early issued bonds expiring, the cash flow shortage problem will gradually appear. The difference compensation mechanism could increase credit, but we still need to guard against the project continuity risk.
Since the project revenue bonds appeared in the market in 2014, it still has some shortcomings. The overall issuing size is smaller than expected. Varied characteristics of different investment projects make it difficult to set up corresponding transaction structures and terms. All those problems can only be gradually solved and optimized through trials and explorations. Compared with general corporate bonds, the issuance of project revenue bonds takes longer time because of multiple links in between. In addition, for investment projects with sufficient cash flow, bank loans are pretty competitive alternatives to project revenue bonds, so the issuers will not choose the latter, which has a relatively cumbersome issuance process.
However, project revenue bonds are the most effective financing methods for fledgling companies with lower-quality projects. As the policy continues to be clarified and the financial institutions continue to explore, the overall issuance size of the project revenue bonds will continue to grow to support municipal infrastructure construction.
 Jianzhong Guan, Dagong Credit Rating Principles, Beijing, The People’s Daily Press, 2014
 National Association of Financial Market Institutional Investors, Non-financial Companies Project Revenue Papers Guidance, 2014
 National Development and Reform Commission, Interim Measures of the Project Revenue Bonds, 2015
 Yunyan Ma, From City Investment Debt to Project Revenue Bonds: On the Change of Local Government Bond Issuance Way, Economic, No.1, 2015
 Jing Du, Xiang Xu, Application of Project Revenue Bonds in PPP Mode, Journal of Industrial, 30(5)