-Abhirup Ghosh (abhirup@vinodkothari.com)

What is partial credit enhancement?

Partial Credit Enhancement (PCE) is a risk-mitigating financial tool where a third party provides limited financial backing to improve the creditworthiness of a debt instrument. It ensures that investors are partially protected against default risk, making it easier for issuers to raise funds at better terms.

The key features of a PCE are as follows:

1. Parties involved: A typical PCE structure would involve at least three parties:

• Issuer: A company or an entity that wants to raise funds by issuing debt instruments;
• PCE Provider or Credit Enhancer: A third party (usually a government agency or a financial institution with strong credibility) that provides the credit enhancement 
• Investor(s): The one who invests in the debt instruments. 

2. Multiple forms: Can be structured in various forms, like guarantee, subordinated line of credit, investment in subordinated tranche, cash collateral etc. 
3. Limited coverage: Unlike full credit enhancement, PCE covers only a portion of the potential losses in case of default. The extent of coverage is pre-fixed and does not extend once the same is exhausted.
4. Improved Credit Rating: PCE lowers the perceived credit risk, leading to an improved bond rating by credit rating agencies. A higher credit rating results in lower interest rates, benefiting the issuer.

Why has this become so important all of a sudden?

The concept of PCE has been in India for quite some time now, and is commonly used in securitisation transactions. However, the Finance Minister’s announcement during Union Budget 2025 about setting up of a PCE facility under the National Bank for Financing Infrastructure Development (NaBFID) has brought this into the limelight.

How does it help issuance of bonds by an infrastructure entity?

Infrastructure development is the backbone of economic growth, but funding large-scale projects such as highways, railways, power plants, and airports requires substantial capital. Infrastructure projects often face challenges in raising funds due to their long gestation periods, high risks, and lower credit ratings. PCE serves as an effective financial tool to improve the creditworthiness of infrastructure bonds, making them more attractive to investors. By providing a partial guarantee or security, PCE helps reduce the cost of borrowing and widens investor participation, ultimately facilitating infrastructure financing.

Challenges in Infrastructure Bond Issuances

Infrastructure bond issuances face several obstacles that make fundraising difficult. One of the primary challenges is low credit ratings. Infrastructure projects, especially those in their early stages, often receive sub-investment-grade ratings (such as BBB or lower), making them unattractive to investors. Additionally, these projects are subject to high perceived risks, including revenue uncertainty, regulatory hurdles, construction delays, and cost overruns. Since many infrastructure projects rely on user charges, such as tolls or metro fares, their cash flow projections can be unpredictable.

Another major issue is the long maturity period of infrastructure bonds. Most investors prefer short- to medium-term investments, whereas infrastructure bonds typically have tenures of 10 to 30 years. This mismatch reduces the appetite for such bonds in the market. Lastly, lack of institutional investor participation further limits the success of infrastructure bond issuances, as pension funds, insurance companies, and mutual funds prefer highly rated bonds with stable returns.

Enhancing Credit Ratings and Investor Confidence

One of the most significant ways PCE helps infrastructure bond issuances is by improving their credit ratings. When a bank or financial institution provides partial credit enhancement in the form of a guarantee or reserve fund, it reduces the default risk associated with the bond. This leads to a higher credit rating, making the bond more attractive to investors. For example, an infrastructure company with a BBB-rated bond issuance may improve its rating to A with a 20% PCE support, or AA with a 50% PCE support thereby increasing demand from investors. A higher rating not only boosts investor confidence but also expands the pool of potential buyers, including institutional investors such as pension funds and insurance companies.

Reducing Cost of Borrowing

By improving the credit rating of infrastructure bonds, PCE directly leads to a reduction in interest costs. Bonds with higher ratings attract lower interest rates, which helps infrastructure companies secure financing at more affordable terms. For instance, without PCE, a BBB-rated bond may require 12%, whereas a bond upgraded to an AA rating with PCE support may only require 9%. This reduction in interest rates can result in significant savings over the life of the bond. Lower borrowing costs also make infrastructure projects more financially viable, ensuring their timely execution and long-term sustainability.

Attracting Institutional Investors

Institutional investors, such as mutual funds, pension funds, and insurance companies, typically have strict investment guidelines that restrict them from investing in low-rated securities. Since many of these investors require bonds to be rated AA or higher, infrastructure bonds often struggle to meet these requirements. PCE helps bridge this gap by enhancing the credit rating, making infrastructure bonds eligible for investment by these large institutional players. This leads to greater liquidity and stability in the corporate bond market, ensuring a steady flow of capital to infrastructure projects.

Why is issuance of bonds helpful/ important for the infrastructure entity?

PCE contributes to the overall development of the corporate bond market by encouraging more issuers to raise funds through bonds rather than relying solely on bank loans. Traditionally, infrastructure financing in India has been dependent on banks, which exposes them to high asset-liability mismatches due to the long tenure of infrastructure projects. By facilitating infrastructure bond issuances, PCE helps shift the burden away from banks and towards a broader investor base. This not only diversifies funding sources but also enhances financial stability in the banking sector.

As per a CII report (2022), the infrastructure financing gap is estimated at over 5% of GDP. Approx. 80% of the investment in infrastructure space is by government agencies (80%), and the remaining 20% comes from private developers. 

As per the National Infrastructure Pipelines, the total investment target was set at INR 111 trillion (USD 1.34 trillion) for the period between FY 20 and FY 25; and only 6-8% (INR 6.66-8.88) of the such targets were expected to be met by bond issuances. Reliance on bond markets is planned to the extent of 6% to 8% (INR 6.66 – 8.88 trillion). As per the said estimates, the average annual issuances should have been INR 1.480 trillion. However, between FY18 and FY22, the issuance of infrastructure bonds has been at INR 5.37 trillion, that is, an average of INR 1.07 trillion per annum, that is a shortfall of ~30% compared to the target.

Furthermore, the issuances have been highly concentrated in the top 5 PSUs. The charts below show the annual bond issuances between FY 18 – FY 22, and share of issuance by top 5 PSUs and others:

Source: CRISIL

The market is dominated by highly rated issuers. In general approx. 75% of bond issuers are rated AAA, and more than 90% of the issuances are by AA and above rated entities. The reason for this dominance by highly rated issuers is the fact that for practical purposes, the most acceptable rating in the infra bonds space is AA, as long term investors like insurance companies, pension funds etc. are by regulation required to invest in AA or above rated papers. 

PCE support from a credible source will help a lot of infrastructure operators, who are stopped at the gate, with ratings in the range of A, with easy access to the market. 

Existing scheme for PCE – why has it not found takers

The existing scheme for PCE was notified by the RBI in 2015. In a nutshell, the scheme provides for the following:

Form of PCE: To be structured as a non-funded, irrevocable contingent line of credit. This facility can be drawn upon in the event of cash flow shortfalls affecting bond servicing.

Limitations: The total PCE extended by a single bank cannot exceed 20% of the bond’s total size; however, overall, the PCE provided by all banks, in aggregate, cannot exceed 50% of the bond’s total size.

Further, PCE can be provided only to bonds which have a pre-enhanced rating of BBB- or above.

Capital Requirements: The bank providing PCE does not hold capital based only on its PCE amount. Instead, it calculates the capital based on the difference between:

• The capital required before credit enhancement.
• The capital required after credit enhancement.

The objective is to ensure that the PCE provider should absorb the risks that it covers in the entire transaction. Illustrating with an example:

Assume that the total bond size is Rs. 100 crores for which PCE to the extent of Rs. 20 crore is provided by a bank. The pre-enhanced rating of the bond is BBB which gets enhanced to AA with the PCE. In this scenario:

1. At the pre-enhanced rating of BBB (100% risk weight), the capital requirement on the total bond size (Rs.100 crores) is Rs.9.00 crores.
2. The capital requirement for the bond (Rs.100 crores) at the enhanced rating (AA, i.e., 30% risk weight)) would be Rs.2.70 crores.
3. As such, the PCE provider will be required to hold the difference in capital i.e., Rs.6.30 crores (Rs.9.00 crores – Rs.2.70 crores).

As can be seen, the capital has to be maintained on the total bond issuance, and not just the exposure. Ironically, this capital has to be maintained until the outstanding principal of bonds falls below the extent of PCE provided​. Usually, the bonds are amortising in nature – that is, the actual exposure of the guarantor continues to come down. Given, however, that default in bonds may be back-ended, the capital has still to be maintained till the redemption of the bonds​. This requires the PCE provider to maintain huge regulatory capital for a significantly long period of time; which also gets reflected in the ultimate cost to the beneficiary, therefore, making it unviable. 

How to make it work?

The FM’s announcement though comes with a lot of promise, as it shows a positive intent. But to make things work, there are quite a few things that should be put into place:

1. Specific applicability: Currently, the PCE framework applies only to banks. For NaBFID to commence its PCE operations, it would be ideal to receive explicit approval from the RBI, even if the requirement is minor or procedural in nature.

2. Limitations: Currently, the RBI’s PCE framework restricts a single entity to providing only 20% of the total 50% PCE limit for a bond issuance. It is recommended that a single institution, such as NaBFID, be allowed to provide the entire PCE, which would enhance flexibility.  The existing framework is not particularly attractive for banks in India. In the infrastructure finance sector, a 20% PCE contribution from a single entity may not be sufficient to secure a strong rating from credit rating agencies. Removing this 20% sub-limit would grant NaBFID greater flexibility while also reducing the time required to identify multiple institutions to fulfill the remaining PCE. Additionally, this change would lead to a reduction in operational expenses associated with coordinating multiple PCE providers.

3. Capital treatment: The current setting of capital requirement makes the transactions very costly. There has to be an alternative way of achieving the objective. Setting the capital requirement as a fixed proportion of the outstanding bond value may not be appropriate, as defaults can occur at any stage. A more effective approach would be to apply the capital treatment for structured credit risk transfer under the Basel III framework, that is SEC ERBA.  Under Basel III, capital requirements are not linked to the total bond issuance size but are instead based on the rating of the tranche and the extent of exposure undertaken. This method ensures that capital is aligned with the actual risk exposure, rather than a fixed percentage of the bond size. Additionally, it accounts for the possibility of defaults occurring later in the bond’s lifecycle, providing a more efficient risk management framework.

4. Credit risk transfer: The PCE framework should specifically allow credit risk transfer by the PCE provider – this will help the PCE provider reduce its exposures, and consequently, extent of capital to be maintained on the PCE provided​. This will help in reducing the cost of the PCE support as well.