European Infrastructure Finance Yearbook - Investing In Bonds ...

Sensitivity and break-even analysis on each
project is undertaken.
This takes into account the specific cash-flow
waterfall structure and repayment terms and
conditions of senior and subordinated debt.
Sensitivity analysis helps demonstrate and
highlight potential downside thresholds under
which subordinated debt may miss a payment of
interest or principal. Stress tests, which are
usually in the form of break-even analysis, assist
in understanding whether a missed payment is
due to any lock-up triggers or other distribution
stoppers being breached and stopping cash
flowing through to subordinated debt (and any
dedicated debt-service reserve running out), or
just the fact that there is not enough cash after
the senior debt has been serviced irrespective of
any distribution trap or stopper. Stress sensitivities
are run on revenues, availability, prices, operating
costs, capital expenditure, inflation, and
refinancing spreads. Typically, the level of stress
placed on subordinated debt is reconciled with the
overall risk of the project and likelihood of a
stress scenario occurring.
Assessing the level and type of credit
enhancement supporting subordinated debt.
Such credit enhancement can take the form of
equity, and project cash flows available after
senior debt-service and liquidity reserves, usually
in the form of dedicated debt-service reserves for
the benefit of subordinated debt. If a
subordinated debt instrument does not have its
own debt-service reserve, it is likely to be more
susceptible to default under stressed scenarios.
Ability for senior debt to raise additional debt or
offer security ahead of subordinated debt.
Most projects allow limited other financial
indebtedness to be raised and security granted to
enhance the rating of senior debt. However, if this
right is too broad, it may affect the level of
subordination, which may change over time.
What will influence the probability of default on
subordinated debt?
Apart from a project’s underlying operating and
business fundamentals, which will be the major
influence on the performance of a project, the
probability of default of a project’s subordinated
debt will be influenced typically by:
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• The contractual and legal structure of a
project, which usually incorporates a predefault
cash-flow waterfall, cash lock-up
and sweep triggers, a timeframe before cash
is released from lock-up, and debt-service
reserve accounts for senior debt; and
• The terms and conditions of the underlying
subordinated debt and any dedicated
liquidity or debt-service reserve allocated for
subordinated debt.
Accordingly, key subordinated debt rating
considerations include: how likely a project will
go into distribution or equity lock-up; how long it
will remain there; what happens to the trapped
cash once in lock-up; and what type of credit or
liquidity support (such as reserves) exist to lower
default probability. If a distribution-trap
mechanism does not last for an indefinite period,
it could be argued that the resumption of debtservice
payments on subordinated debt-depending
on the project, scenario, and
subordinated liquidity reserves--is likely to be
certain. The analytical challenge is determining
the duration of any under performance. We
typically run stress scenarios for each project to
analyze how long it would take for a rated
tranche of subordinated debt to default under
varying scenarios. Nonetheless, any significant
deterioration in the performance of a project is
likely to magnify the level of potential default on
any subordinated debt.
What will affect the recovery of
subordinated debt?
If a project suffers from poor performance and
there is a missed payment of interest or principal
on a project’s subordinated debt, a major
determinant on the recovery prospects of
subordinated debt is whether senior debt has also
defaulted. If senior debt has not defaulted, it
would prevent any recovery action of
subordinated debt until senior debt is repaid or
defaults. If this was to occur, there may be limited
or zero recovery for subordinated debt.
Should senior debt default or be repaid, factors
that would influence the recovery prospects of
subordinated debt include:
• The nature of the default;
• The type of security, collateral, and any
first-loss protection;
NOVEMBER 2007 ■ 119