The Term Structure of Credit Spreads in Project Finance

Abstract

This paper analyses the peculiar nature of credit risk in project finance by means of a comparative econometric analysis of ex ante credit spreads for a large cross section of international loans and bonds between 1993 and 2001 in both industrialised and emerging countries. Our main contribution relates to the analysis of the term structure of credit spreads for project finance loans compared to other loans and bonds. For both investment-grade and speculative-grade bonds used for purposes other than project financing, we find that the term structure of credit spreads can reasonably be approximated by a linear positive function of maturity, once other relevant micro and macro risk factors have been controlled for. For project finance loans, instead, we show that the term structure of credit spreads is hump-shaped. This result applies to both industrialised as well as emerging countries and appears robust to a large number of sensitivity tests, controlling also for possible sample selection bias or endogeneity of maturity choice. We emphasise a number of key features of project finance structures that might underlie this finding. In particular, we illustrate the mechanisms by which higher leverage, short-term liquidity concerns due to the exclusive reliance on project cash flows as well as the sequential resolution of risks along various project advancement stages might all alleviate the perceived risk of longer-maturity project finance loans. This paper offers a number of policy implications. It provides a cross-country assessment of the riskmitigating role of explicit or implicit guarantees from multilateral development banks and export credit agencies in project finance. It also makes a number of suggestions for bank regulators on how to effectively align capital requirements with the actual term structure of credit risk in project finance. In particular, our results indicate that a linear maturity adjustment to regulatory capital with slope inversely related to the probability of default might not be applicable to project finance exposures. We acknowledge, however, that introducing different maturity adjustments for different asset classes, while improving the risk sensitivity of capital requirements, would also add to the complexity of their implementation.