Contract risks and credit spread
            determinants in the international project bond market
International bond markets have become
            an increasingly important source of long-term capital for
            infrastructure projects in emerging market economies over
            the past decade. The Ras Laffan Liquified Natural Gas (Ras
            Gas) project represents a milestone in this respect: its
            $1.2 billion bond offering, completed in December 1996, has
            been the largest for any international project. The Ras Gas
            project has the right to extract, process, and sell
            liquefied natural gas (LNG) from a field off the shore of
            Qatar. The principal off-taker is the Korea Gas Corporation
            (Kogas), which resells most of the LNG to the Korea Electric
            Power Corporation (Kepco) for electricity generation. In
            this clinical study the authors analyze the determinants of
            credit spreads for the Ras Gas project in terms of its
            contractual structure, with a view to better understanding
            the role of contract design in facilitating access to the
            global project bond market. Market risk perceptions have
            long been recognized to be a function of firm-specific
            variables, particularly asset value as embodied in
            contracts. The authors therefore study the impact of three
            interlocking contracts on the credit spreads of the
            project's actively traded global bonds: the 25-year
            output sales and purchase agreement with Kogas-Kepco, the
            international bond covenant, and an output price-contingent
            debt service guarantee by Mobil to debt holders. Using a
            sample of daily data from January 1997 to March 2000, the
            authors find that the quality of the off-taker's
            credit-and, more important, the market's assessment of
            the off-taker's economic prospects-drive project bond
            credit spreads and pricing. In addition, seemingly unrelated
            events in emerging debt markets spill over to project bond
            markets and affect risk perceptions and prices in this
            segment. Judicious use of an output price-contingent debt
            service guarantee by shareholders can significantly reduce
            project risks, and markets reward issuers through tighter
            credit spreads. Bondholders and shareholders share residual
            risks over time, despite covenants meant to preempt risk
            shifting. This type of risk shifting originates from
            incomplete contracts and the nonrecourse nature of project
            finance. It does not necessarily result from a deliberate
            attempt by management to increase shareholder value at the
            expense of debt holders by pursuing high-risk, low-value
            activities, although project managers and shareholders could
            still exploit their informational advantages by leaving
            output supply contracts incomplete in ways beneficial to
            their private interests. The results hold important lessons
            for global project finance. Projects incorporating certain
            design features can reap significant financial gains through
            lower borrowing costs and longer debt maturities: Judicious
            guarantees by parents that enjoy a particular hedging
            advantage enhance a project's appeal, as reflected in
            favorable pricing. Pledging receivables rather than physical
            assets as collateral and administering investor cash flows
            through an off-shore account offers additional security to
            debt holders. Projects should use their liability structure
            to create an implicit option on future private debt
            financing that matches the real option of a project
            expansion. The finding that bondholders bear residual risks
            means that shareholders can reduce their risks arising from
            bilateral monopolies and buy insurance against unforeseen
            and unforeseeable events.