The United States has a tremendous need for infrastructure investment, but it remains slow in adopting public-private partnerships – or P3s – compared to other countries.
President Trump’s infrastructure policy plans to address these shortcomings by limiting government spending to $200 billion over the next decade, while removing red tape and making it easier for municipalities to complete P3 deals to address infrastructure underinvestment. However, there’s a lot of uncertainty about Trump’s ability to execute on these plans given the lack of progress in healthcare and tax reforms.
In this article, we will look at the need for infrastructure investment in the United States, as well as the role that bond insurance plays in P3 deals from the standpoint of both issuers and investors.
A $3.6 Trillion Need
The United States requires more than $3.6 trillion in infrastructure investment by 2020, according to the American Society for Civil Engineers (ASCE), which gives the country’s infrastructure a D+ rating. Despite bipartisan support for an increase in infrastructure spending, there were just $1.7 trillion in infrastructure-related municipal bonds between 2003 and 2012, and only about $2.4 billion worth of P3 deals were put together in 2015.
There’s little doubt that there’s a lot of work to be done. For example, public transportation is chronically underfunded with a $90 billion rehabilitation backlog. These dynamics come despite strong demand in terms of both growth and need. The number of individuals using public transportation has risen by about a third over the past 20 years, but only half of Americans can even get to a grocery store on public transportation.
President Trump’s infrastructure spending plan will include $200 billion in direct federal spending over the next decade on everything from roads to broadband. In addition, the president plans to incentivize states, cities and private investors by eliminating the burden of regulations. The idea is to open the door to more efficient P3 deals rather than focusing on government spending as a conduit to improve infrastructure.
Municipal bonds will continue to play a large role in these P3 deals as a source of low cost funding. According to the U.S. Conference of Mayors data, local and state governments financed nearly $1.7 trillion in infrastructure projects between 2003 and 2012 that would have cost cities up to $500 billion more through alternative means – dramatically increasing the cost to taxpayers for critical infrastructure projects that needed to be finished.
P3 partnerships have become increasingly common in the United States for both financial and logistical reasons. With many states facing budgetary challenges, P3 deals enable states to offload some of the financial and completion risks associated with these projects. The private sector also tends to be better equipped to handle complex projects since their incentives are better aligned (e.g., there’s a profit motive in place).
In general, P3 bond yields tend to be higher than general obligation bonds due to their increased credit risk. Municipalities theoretically have unlimited taxing authority to back up GO bonds, while P3 projects have only project assets and the credibility of the parties involved. This means that municipalities have an opportunity to step in and provide cheaper financing for these projects, which creates a significant opportunity for closing the infrastructure gap.
The Importance of Bond Insurance in the Infrastructure Space
While municipal bonds are more aligned to become a financing tool for the infrastructure space because of their inherent nature, there are specific subcategories where these types of bonds have been extensively used in the past. For example, tax-free bonds are commonly used for primary and secondary schools, acute care hospitals, water and sewer facilities, highways, public power and mass transit systems. Federally-supported programs like the Transportation Infrastructure Finance and Innovation Act (TIFIA) have also been used in public-private partnerships aimed at advancing large-scale infrastructure projects like mass transit.
As far as bond insurance is concerned, it is well known that these provide a guarantee for scheduled payments of interest and principal on a bond if an issuer were to default. While defaults are rare in the broad municipal bond market, infrastructure bonds have been notoriously risky revenue bonds. A great example of these risks is South Carolina’s Interstate 185 toll road, which became the first P3 default in 2010 after toll revenues failed to meet the project’s bond payment obligations.
Bond insurance can help investors to avoid these situations while helping municipalities to ensure smooth operation. Investors can leverage the expertise of bond insurers in credit analysis to avoid problematic bonds and stick primarily to insured infrastructure bonds. Municipalities, on the other hand, benefit from lower borrowing costs since insured bonds tend to have much lower interest rates – especially when it comes to somewhat risky infrastructure bonds.
For instance, Assured Guaranty conducts a detailed financial review of the project; an operational review of the developer, construction companies and operators; and a financial review of the financial stability of the bond. With $3.7 billion in net par value outstanding at a BBB+ rating, the company has tremendous experience in analyzing and insuring infrastructure bonds in both the United States and around the world.
There’s little doubt that bond insurance will play an increasingly important role in the municipal bond market, especially with the troubles in Puerto Rico. With capital flowing into infrastructure, there will be an influx of lower-rated bonds backed by public revenue sources, such as tolls or energy credits. Both issuers and investors could benefit from the addition of bond insurance in these areas.
There are several reasons why bond issuers might want to consider insurance for infrastructure bonds, including:
- Improved Marketability. Smaller municipal issuers often use bond insurance to access capital markets with new debt offerings at a lower all-in interest rate and greater liquidity than would be possible on an unguaranteed basis.
- Greater Confidence. Newer types of municipal bonds – such as green infrastructure bonds – have a limited history, which means that bond insurers can step in and help to provide greater confidence for investors.
Similarly, there are major reasons why investors might seek out insured bonds when looking to invest in infrastructure bonds, including:
- Lower Default Risk. Infrastructure bonds are a great way to diversify, but they tend to have lower credit quality than other municipal bonds. Bond insurance can help address this shortcoming by guaranteeing the on-time repayment of interest and principal.
- Diversification. Infrastructure bonds offer significant diversification in terms of asset class and duration. Consider this: for those approaching retirement, insured bonds provide guaranteed payments over a long timeframe at attractive interest rates.
The Bottom Line
The United States requires nearly $4 trillion in infrastructure investments to modernize roads, bridges and other investments. Municipal bonds will remain a cornerstone in financing these projects given their tax-advantaged status and large pool of individual and institutional buyers.
Bond insurance plays a critical role in the municipal bond market by increasing the marketability of smaller issues. With P3 infrastructure investments on the rise, bond insurance could become even more important as municipalities with lower-rated infrastructure revenue bonds look forward to finance projects. The upshot is that this investment could help close a significant gap in U.S. infrastructure spending over time.