“P3” BONDS, DEBT ISSUED BY public/private partnerships, are gaining recognition and popularity in Canada. They offer investment-grade security with the kind of yields that usually go with junk bonds. But P3s are not a free ride; they are complex packages of deals made between governments and the companies that build the infrastructure required by those governments.

There are about 20 P3 bond issues outstanding in Canada, and the market is growing. These issues – structured to provide a way for governments to design, build, finance and operate projects such as roads, hospitals, schools and even prisons – have long terms and usually amortize the principal, paying it back gradually rather than waiting for the bond to mature. All P3s shift the investor’s risk from the usual interest rate cycle to the structure of the P3 bond.

A well-known P3 bond issue, the 407 International 5.75% issue due Feb. 14, 2036 – a senior bond rated AA (low) by DBRS Ltd. – was designed to finance and build the toll expressway across Toronto’s northern boundary. This bond recently has been priced at $114.95 to yield 4.70% to maturity. Compared with the Government of Canada 5.00% issue due June 1, 2037 (recently priced at $142.20 to yield 2.63% to maturity), the 407 issue offers 207 basis points of additional yield.

There are other ways to get a competitive return in an investment-grade bond. For example, a Great-West Lifeco Inc. 6.56% issue due Dec. 13, 2027, recently priced at $120.42 with an AA (low) rating from DBRS offers a 4.78% yield to maturity. But life insurance bonds are “macro-sensitive”; insurers, after all, get much of their income from bonds. In the present environment of low interest rates, insurers’ earnings have suffered.

On the other hand, P3s have more specific drivers. For example, matters such as the reputation of the builder in the partnership may be more important than interest rate trends.

P3s, in spite of their complexity, are a fact of life in the bond market. They are in the DEX universe bond index, notes Tim Hicks, vice president with Canso Investment Counsel Ltd. in Richmond Hill, Ont. Therefore, large bond funds are likely to include P3s when the funds have mandates to replicate the Canadian bond market.

The liquidity of P3s has improved a great deal, notes Michael Swan, associate portfolio manager with Canso. Some P3s, such as the one issued by Plenary Properties LTAP (a partnership that is building an Ottawa building for a unit of the Department of National Defence), ultimately have federal government money – although not a contractual guarantee – behind them.

In the Plenary Properties deal, which matures in 2045, the investor gets a 4.35% yield on a bond with a relatively short, 14-year duration – a third less than what a conventional bond would carry because of the amortizing process that speeds up the return of capital. The reduced duration means this bond will have relative insulation from market interest rate changes vs what a conventional bond with a fixed maturity and a final repayment of principal would offer.

The payoff goes with the risks, however. As Hicks notes, the government could borrow at 2.6%, the current federal long bond rate, and hire a contractor to put up a building rather than enter into a P3 contract. But from the government’s point of view, the chances that the job might not be completed on time, and potential performance issues with subcontractors, make it worth paying the extra interest.

“Governments do not like open-ended construction projects,” Hicks explains. “So, the P3 partnership controls costs and wraps up the entire job in a more secure package.”

It also transfers a good deal of risk to the bond’s buyers who, of course, get a substantial yield boost for taking on that risk.

There have been no defaults among the 15 P3 projects that DBRS has rated, says Eric Beauchemin, managing director of the credit-rating agency. But there are potential problems. The Strait Crossing Development Inc. bond issued for the bridge that connects New Brunswick with Prince Edward Island, for example, started out as an A credit and has been downgraded by DBRS to BBB (low) due to lower than expected traffic volume.

Clients who buy P3s take on risks related to construction and performance, deal complexity, potential widening of the rate spread if liquidity problems develop – think of non-bank, asset-backed commercial paper when that market froze – and even the credit quality of the governments, which mostly are provincial, that are partners in the projects. These risks are, however, mitigated by letters of credit provided by the financing partners, performance bonds by the contractor and the fact that the projects are large. If a bridge is not getting built, that will be evident to all.

Thus, the client’s dilemma: P3s are sound debts, but their method of packaging and shifting risk to the client adds to the analysis chore, says Chris Kresic, partner and co-head of fixed-income at Jarislowsky Fraser Ltd. in Toronto: “Each deal is different. But as the bonds get older and the construction jobs are done, the bonds and the projects move into their performance phases and the risk diminishes.”

For advisors, however, the problem remains that P3s are the opposite of the kind of easily described, single-maturity bond that the market prefers, says an investment banker who puts the deals together. The attraction is that P3s offer yields that usually go with subordinated debt or junk but have the security of government-paid cash flows. The P3 bonds enter the secondary market and are then available for when ratings change or spreads tighten.

That’s when investors can get superior yields and diversification into more pricing factors than those that drive returns on conventional government bonds.

“If you find [a P3] in the secondary market in the post-construction phase when construction risk is past,” says Kresic, “and you can pick up the bond with its yield boost over federal debt, you’d have a good deal.”IE

© 2012 Investment Executive. All rights reserved.