Developing World Loans Offer Potential Returns
By: David G. Creighton
The current low yield on bonds is prompting pension plan sponsors to seek other investment opportunities. David G. Creighton, of IFPT Management Inc., examines the use of International Financial Institutions project finance loans made to the developing world.
If you accept U.S. equities as a proxy for Canadian and world equities, then you might be reassured by the real or inflation adjusted return of seven per cent per annum that they produced from 1926 to 2003. Since this time span covers periods of prosperity and depression, of war and peace, of deflation and inflation, one would think that this rate of return would constitute a reasonable guideline for estimating equity returns for the coming decades.
One, however, would be wrong.
This seven per cent return can be broken down into three components: beginning yield (4.5 per cent) real growth of dividends (one per cent) increase in valuations (1.5 per cent) Today’s yield, however, is closer to two per cent. Real dividend growth may actually increase to 1.5 per cent but valuations – having moved from 10 to 30 times earnings – will likely revert back to their historic average of 15 times. Given this new equation of ‘2 + 1.5 – 1,’ the result is an expected return of 2.5 per cent. In other words, the days of seven per cent returns are behind us. The same demographic savings dynamics that pushed valuations up will reduce them in the decades to come as the western world will, for the first time in history, become a net seller of financial assets in order to meet the pension, 401(k), and RRSP requirements of our aging and longer-living populations. Unless you can build a portfolio with a three per cent dividend yield and a real dividend growth rate of five per cent, the broad equity markets will not give you the return your liabilities require.
Unfortunately, the outlook for bond returns, with the exception of Real Return Bonds and other inflation indexed instruments, does not look any better. The unprecedented size of the U.S. fiscal and current account deficits, and the S&P’s projected increase in western governments’ debt to meet the requirements of social and healthcare systems, may cause OEDC governments to monetize their obligations by allowing a gradually increasing rate of inflation. Periods of secularly rising interest and inflation rates have, in the past, resulted in up to 40 years of negative real bond returns (1940 to 1979: -1.8 per cent per annum).
Needless to say, with the prospect of only marginal expected returns from equities, a reversal of the 20 year trend in interest rates, and the realization that pension funds need to match their assets to their liabilities, the development of alternative investments has become an essential part of building a prudent portfolio.
An ideal investment within this new category would have low correlation to other investments, be insulated against increases in inflation and rising interest rates, have safety of principal with low volatility and, ultimately, have a positive Alpha and high Sharpe ratio. One solution is to invest in a trust that participates in a broad range of project finance loans made by a selection of International Financial Institutions (IFIs) to the developing world. Inflation sensitive, these funds have demonstrated a low but positive correlation to a wide selection of traditional investments, low volatility and, hence, positive Alpha and high Sharpe ratios. Moreover, though the assets of the trust are foreign, the trust may not be considered foreign property, as defined by the Income Tax Act.
While at first glimpse these emerging market project finance loans could be considered risky investments, historical data shows that the actual write-off of the so-called B-Loans is well below one per cent – a strong indication of safety of principal.
The IFIs that generate and service the loans include the International Finance Corporation (the private sector sister of the World Bank), the European Bank for Reconstruction and Development (which has been instrumental in the emergence of eight of the 10 countries that have recently joined the EU), the Asian Development Bank, the Inter-American Development Bank, and Export Development Canada. Each of these institutions enjoys a form of ‘preferred creditor status.’ What this means is that in times of stress, such as the Russian default in 1998, the hard currency necessary to service the debt will continue to be made available, while traditional foreign denominated sovereign bonds will be subject to default. In essence, this creates an opportunity to invest in high quality projects, with the emerging market country risk largely mitigated.
Multi-staged Due Diligence
The key to maintaining the low volatility nature of the trust is the development of a multi-staged due diligence process by which each loan investment is gauged, which includes the underlying IFI’s extensive pre-screening analysis.
Each loan is screened for a variety of risks, which include: Country Risks, such as the political and economic environment and currency convertibility. It should be noted that rating agencies typically assess Bloans as though foreign exchange transfer risks are mitigated. Counterparty Risks, where all parties involved in the projects are reviewed for their ability to remain viable throughout the life of the loan. In many cases, internationally recognized companies are sponsors to the projects and the greatest risk is during the initial construction phase. The IFIs, which oversee and manage the loans, all carry ‘AAA’ foreign currency credit ratings. Market Risks: Is the demand sufficient for the financial models to unfold as expected? What is the current level of domestic and international competition, and how is it expected to develop? Operating Risks, which can be quite extensive but may include such questions as: what is the technology used for the project? What are the risks in delivering the product to the consumer? What is the source of raw materials and what is the quality and transparency of management? Credit Risks: Most projects come with comprehensive security packages which typically include a pledge of the borrower’s shares, mortgage on fixed assets, pledge of accounts, assignment of insurance, and, where relevant, assignment of key contracts. All that notwithstanding, it is still necessary for the manager to understand all the credit aspects and not simply rely on the underlying security. Environmental Risks: It has been shown that projects that are beneficial socially and environmentally receive stronger support from the community and are much more likely to perform as expected.
Also, where warranted, a site visit is conducted in order to form independent opinions on the financial projections of the business, meet management, and ensure the adherence to environmental criteria and anything else which may be a consideration to the well-being of the project.
With regard to exposure limits within the portfolio, the manager sets strict standards in order to optimize diversity while limiting systemic risk.
Lender Of Record
Under the B-Loan structure, as the IFI is the lender of record and the servicer of the loan, limits are set on the minimum exposure that the IFI will maintain in order to ensure that all parties are properly motivated to secure the well-being of the project. In the event of non-accrual or default, the IFI is in a position to work with the borrower’s management and the government in order to return the project to current status. Because of this hands-on dealing and the extensive capabilities of the IFIs, write-offs are well below that of the public debt markets in these countries. The value of the developmental role and the technical assistance that is provided by these institutions is shown very clearly in the case of a number of developing countries that have recently ‘emerged.’ Beyond the new members of the EU, consider that Russia and Mexico – which both have experienced crises over the past decade – and China now have investment grade ratings from at least one international rating agency.
It has been proven over the years that prudent selection and analysis of project finance loans in the emerging markets, coupled with the tried and tested ‘preferred creditor status,’ creates an exceptional pool of assets that are worthy of a pension portfolio. In addition, the ability to gain inflation hedged, absolute return, non-correlating, foreign exposure that is exempted from the foreign property rule should be a consideration of all prudent managers.
David G. Creighton is president and CEO of IFPT Management Inc.
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