Infrastructure and energy are two of the most important cornerstones of any country’s economy. All economic sectors are in need of sound infrastructure and a reliable supply of energy. Manufacturing requires uninterrupted and stable power, and commerce can only thrive if raw materials and manufactured goods are transported through well-maintained roads, railroads, ports, and airports. A power failure in a hospital may have dire consequences, and proper healthcare services can only be provided in hospitals built to match the needs of the population and the latest medical technologies.

The growing need for building new infrastructure, and for rehabilitating existing ones, results in an immense need for funding. This need is particularly heightened if a country is in a key location in terms of global trade routes and thus requires adequate transportation infrastructure; has a sizeable population or has had a sudden rise in its population due to increasing immigration and hence has increased infrastructure (both economic and social) and energy needs; requires the development of many projects at once, etc. As a country that checks all of these boxes, Turkey has an extensive need for funding for infrastructure and energy projects.

Because of increasing banking regulations, the latest example of this being the Basel III regulations, banks can no longer singlehandedly meet the financing needs of sizeable infrastructure and energy projects. Given the capital adequacy requirements applicable to banks and the limits on exposure to certain countries, areas, sectors or sponsors, the financing needs of investors may not be met through conventional methods of funding. This is especially the case for countries such as Turkey where multiple and voluminous infrastructure projects are developed at the same time. To overcome this funding gap, investors, lenders, and governments are seeking ways of mobilizing alternative forms of financing. An example of this is the rise of sukuk financing, which has become a prominent alternative source of financing in recent years.[1] Another method of alternative financing for infrastructure and energy projects, which has been widely used throughout the world but, save for very limited and atypical earlier cases,[2] has only recently made its mark on the Turkish project finance market, is project bonds. In this article, we will introduce you to the concept of project bonds by focusing on how they differ from traditional debt financing or corporate bonds while also touching upon the recent developments in Turkey that intend to set the legal framework governing the concept of project bonds.

Project bonds: an overview

Project bonds deviate from regular corporate bonds in that they are issued to finance a specific project and the bond proceeds are paid exclusively from the cash flow generated by that project as opposed to the overall revenue of the issuing entity. This means that project bonds are long-term investments, especially when issued to fund greenfield projects involving an extensive construction phase. As a result, project bonds are particularly attractive for capital markets investors looking for stable and long-term investment opportunities, such as insurance companies, wealth funds, and pension funds. Although the volume of investments made by these institutional investors utilizing project bonds is still not at desired levels, these investors, particularly insurance companies, are becoming increasingly more comfortable with project bonds.[3]  

Project bonds v. debt financing

As project bonds still stand out as an emerging concept for certain regions, there is a vivid discussion comparing the viability of bond financing with the assumed benefits of the more established conventional debt financing method for infrastructure investments. Some of these discussions focus on the accessibility of project bonds for professional investors while some touch upon the more cumbersome financing terms that bond structures may entail. Let us review some key arguments.

A recurring argument against the use of project bonds from the issuer’s perspective, especially where the financing relates to greenfield projects, is the issue of “negative carry”. The concern here is that the issuer receives the funds at once and upfront at closing, whereas the capital expenditure costs spread over a construction period lasting several years. During this period, the issuer is required to pay interest on the amounts that are neither needed nor used. Still, this problem can be overcome with a delayed draw mechanism whereby the funds are made available with multiple draws in line with construction needs or with a combination of project bonds and debt financing.[4]

Another reason a company may prefer debt financing over bond financing may be that the company has limited access to capital markets due to the size of its business or its financial status[5] or because of confidentiality concerns.[6] However, these are not likely significant concerns for companies taking on major infrastructure and energy projects, which require a sizeable investment by nature and are closely followed up by all stakeholders. On the other hand, as stated above, traditional financing may not always be available due to capital adequacy requirements and exposure limits, which may lead companies who are facing such issues to turn towards bond financing.

Finally, an investor may prefer the flexibility of debt financing to the strict terms of bond financing in terms of drawdown schedules, the ability to seek amendments and waivers, access to refinancing, etc. This usually does not constitute an obstacle to using project bonds for infrastructure or energy projects, given that such projects will involve feasibility studies that identify all applicable risks and financing models that make provision for the same. However, in developing or less developed countries, there may be risks that cannot be fully identified from day one, which may result in the need for additional or altered financing. Examples of these risks include exchange rate fluctuations, sudden increases in construction costs due to general economic recession or international trade regulations, etc. On the other hand, project bonds allow issuers to stabilise their financing costs for the lifespan of the project, and project bond covenants are usually less strict compared to the covenants undertaken for debt financing.[7]

Project bonds in practice

An area in which project bonds are particularly used throughout the world is the energy sector. This is because energy projects promise stable, long-term income for the issuer based on off-take arrangements/power purchase agreements. Similarly, project bonds are widely used to finance infrastructure projects based on availability payment structures where the State party commits to making periodic payments to the project companies. These are ideal projects for bond issuances as they are less susceptible to fluctuations in demand amounts. Infrastructure projects with usage-based fees are considered more risky when compared to availability-based contracts given the potential issues with the predictability of future usage unless there are state guarantees in place mitigating the demand risk.

The number of recent examples seen around the world highlight the importance of project bonds in major infrastructure and energy investments. In the last few years alone, some of the largest projects in various sectors were financed through project bonds. These include the USD 1.571 billion financing of the Pedemontana-Veneta highway project in Italy,[8] the CAD 1.4 billion project bond issue for the Alberta Powerline Project in Canada,[9] the USD 2 billion dual-tranche issue by the Indonesian power producer Paiton Energy,[10] the USD 1.1 billion bond financing by Mitsui & Co., Ltd. to procure refinancing for its floating production storage and offloading charter project in Brazil,[11] and the USD 1.4 billion project bond issue by Australia Pacific LNG to refinance its natural gas project in Australia.[12] The next few years promise even bigger projects, as evidenced by plans to issue project bonds for the high-speed train project between California and Las Vegas, which is currently in the works and has recently obtained approval for a USD 3.2 billion bond issue from California.[13]

Is Turkey ready for the era of project bonds?

Project bonds have already made their mark in Turkey with the Elazığ Healthcare Campus project. The project, which is currently being developed under Law No. 6428 on the Construction, Renovation, and Purchase of Services by the Ministry of Health by way of the Public-Private Partnership Model and Amendments to Certain Laws and Decrees with the Force of Law (“BLT Law”),[14] was financed through a project bond issuance. The 20-year bonds, which were classified as “green and social,” were issued by the Luxembourg entity ELZ Finance S.A. who went on to on-loan the bond proceeds to the Turkish project company, ELZ Sağlık Yatırım A.Ş.[15] In order to obtain an investment rating, the bonds were credit enhanced by the European Bank for Reconstruction and Development (EBRD) and political insurance was provided by the Multilateral Investment Guarantee Agency (MIGA).[16]

The fact that the project bonds for the Elazığ project were issued in international markets by an entity incorporated under the laws of Luxembourg begs the question: Is it possible, and feasible, to issue project bonds in Turkish capital markets? To answer this, we should have a look at the applicable capital markets regulations as well as the general financial challenges with bond issues in Turkey.

Legal challenges

The Capital Markets Code No. 6362[17] and the Debt Instruments Communiqué (VII-128.8)[18] regulate the issue of bonds under Turkish law. Until very recently, the only provision of Turkish law that treated project bonds differently from corporate bonds was Article 9(9) to the Debt Instruments Communiqué, which stipulated that the issue limits set out under the Debt Instruments Communiqué do not apply to debt issues sold to investors abroad that are made to fund or refinance projects carried out under Law No. 3996 on the Procurement of Certain Investments and Services under the Build-Operate-Transfer Model[19] (“BOT Law”) or the BLT Law. However, in February 2020, the Omnibus Bill No. 7222 Amending the Banking Law and Other Laws, which has introduced Article 61/B to the Capital Markets Code No. 6362, finally made the statutory introduction to project bonds in Turkey in a way that set the backbone and paved the way for secondary legislation to further put some meat on the skeleton. Accordingly, through project funds (which have also been introduced with this February amendment), project developers will be able to issue “project-backed securities”, i.e., project bonds, which will be backed by the proceeds of the assets and rights generated by a project. As noted, specifics on the issuance and regulation of project bonds, including the type of assets and rights that will constitute the subject matter of project bonds, are not detailed in Article 61/B, and will be determined by the Capital Markets Board through secondary regulation.[20] The Capital Markets Board published a draft of said regulation on its website back in July 2020 and requested interested parties to submit their comments by August 2020, but no further news have surfaced as of yet. 

The forthcoming secondary regulation is certainly good news, as the current regulations, which were drafted with only corporate bonds in mind, fall short in taking into account some of the characteristics of the entities that may issue project bonds, as well as the project related structures. To give an example, pursuant to Article 16 of the Borsa İstanbul A.Ş. Listing Regulation,[21] in order for debt securities to be listed in Borsa İstanbul (i.e., Istanbul Stock Exchange), three (or in certain cases two) years must have passed since the incorporation of the issuer, the financial statements and independent audit reports of the last two years must be annexed to the bond prospectus, and the issuer must have made profits in the last two years (or in certain cases only in the preceding year). These time barriers make the issuance of project bonds by a Turkish project company extremely difficult, if not impossible, as these companies are usually SPVs established specifically for the purposes of the project and therefore cannot profit until the project is well underway. Similarly, these project companies are commonly subject to strict term requirements in terms of the construction of the relevant facilities, requiring them to raise financing immediately to fund the sole establishment purpose of the companies without the luxury of waiting for three years after their incorporation.

Another similar barrier to the issuance of project bonds subject to Turkish laws is the issue limit (i.e., leverage ratios) imposed under Article 9 of the Debt Instruments Communiqué, which is determined based on the issuer’s amount of equity. In a project finance deal, the sponsors cannot be expected to inject sufficient equity to meet these limits at the offset. Although these issue limits do not apply to debt issues sold to investors abroad that are made to fund or refinance projects carried out under the BOT Law or the BLT Law, they still apply to bonds sold to investors in Turkey and bonds issued to fund or refinance projects that are carried out under different laws (e.g., energy projects).

It is expected that the secondary regulation to be introduced by the Capital Markets Board will take these issues into consideration, and remove these obvious barriers to the issuance of project bonds in the Turkish capital markets. The draft communiqué seems to be capable of resolving some of these key issues, as it provides that the issue limit of project bonds can be up to 70% of the total project cost and expressly sets out that the issuer can be a newly incorporated special purpose vehicle.

Financial challenges

Another key challenge in issuing project bonds in Turkey is, independent of the legislative background, the lack of a sufficiently large and active bond market. Although Turkey is one of the largest local currency bond markets among developing countries, the size of its capital markets is small when compared to that of developed countries and government bonds make up the majority of debt instrument issues. As of December 2019, the total nominal value of corporate domestic bonds amounted to roughly USD 18.5 billion, with almost 70 % of these bonds issued by banks.[22]

The credit rating of the Turkish government is another challenge not only for issuing project bonds in Turkey but also for using project bonds to finance major projects in Turkey. These projects usually involve payments made by government entities (e.g., availability payments or power purchase fees) and/or guarantees or debt assumption by the State. With the big three credit rating agencies having assigned Turkey below-investment grades (BB- (negative) by Fitch, B2 (negative) by Moody’s, and B+ (stable) by S&P), projects depending on government payments may not be attractive to investors. However, as seen from the example of the Elazığ project, this challenge can be overcome through a credit enhancement mechanism, which serves to increase the individual credit rating of projects by ensuring an additional layer of financial safety in favour of the project/project companies.

Conclusion: A new era?

The Elazığ example has shown that Turkish project developers are more than open to the idea of financing their investments through project bonds. Once the Capital Markets Board issues its secondary regulation on project bonds, project developers will be able to utilize this alternative source of funding directly in the Turkish markets. To ensure that project bonds will be a viable option, it should be made sure that the detailed legislative framework answers the project developer’s needs.