Eastern Europe has a sketchy record in road finance, despite its political position as the frontier of the European Union. That Croatia, not even an EU accession country, should be the source of the first road bond out of the region is surprising. That the bond went ahead uncovered and sold down strongly makes it one of the most impressive showings in infrastructure finance in 2003.

The main sponsor of the Bina Istra concession is Bouygues, the French construction and toll road specialist that operates the M5 in Hungary and the A28 in France - another road finance trailblazer. Bouygues, largely as a result of changes in ownership structure, owns 61% of Bina Fincom, which in turn owns 51% of the project company. It also owns 16% directly in the project, alongside the two largely silent partners Croatian Motorways (14.8%) and Istarska Autocesta (2.2%).

The project involves three phases: 1A (completed and operational since 1999, and awarded in 1995), 1B (including construction of the Mirna viaduct), and Phase 2, creating a Y-shaped system running from the south into central Croatia and then branching north-east and north-west. Phase 1B consists of three sub-phases: 1B1, 1B2-1 in the west, and 1B3 in the south. The majority of Phase 1B will be new construction except for a portion of 1B2-1, which already exists but is not yet in operation.

The 1A phase construction used Eu89 million ($102 million) of bank debt from RBS, WestLB, BankAustria, Dai-Ichi Kangyo Bank, and CDC, covered by Coface. This issue refinances that portion, and raises funds for the second phase. According to Henri Chauveau at Bouygues, the company always intended to use a bond issue, although in 2002, when financial advisor UBS Warburg was appointed, conditions were not promising.

This is because Croatia's sovereign rating of BBB- is the lowest investment grade possible and any fixed income offering with less than a sovereign guarantee would come in lower. It also precluded the involvement of the risk-averse monolines. But uncovered bonds - with isolated examples - have not been a feature in European road finance to any great degree, and it has been hard to finance a road in Eastern Europe.

The solution for the government, and for the sponsor, was to structure the concession so as to avoid a blanket guarantee, but to structure the concession sovereign rating to make it robust enough to come close to the ceiling. It also was designed to make traffic risk the responsibility of government, and still allow its obligations to fall should the road perform well.

This solution is centred on a six-month debt service reserve account (DSRA), funded at close, and the way by which the road deals with year-on-year variations in traffic volumes. The government uses traffic forecasts to project what it will require to subsidize the project above projected revenues. The road earns money from one tunnel crossing, and a projected viaduct, but these are likely to account for at most 25% of project revenues.

The government payment is sized to cover interest payments, operations and management and a 5% return on equity. In the event that the traffic comes below forecast, the DSRA would be drawn upon, and replenished before the equity is paid. The DSRA runs to 12 months from 2003 to 2009, and to 15 months from 2010 to the maturity of the bonds in 2022.

This structure allowed the bonds to be rated BB+ - tantalisingly close to the investment grade level. The deal, however, was not explicitly pitched to investors as a toll road credit, more as structured government debt. Croatia has a history of borrowing in euros, and the deal was priced off government debt. The Eu210 million deal was launched at 365bp over the 6% 2016 Bund. Since then, it has traded 60-80bp within that launch spread.

According to a banker at financial advisor and bookrunner UBS, the deal sold 39% to UK investors, 23% to Germans, 11% to Croatians, 8% to the French, 6% each to Austria and the Benelux, and 4% to Greek buyers. It was 50% oversubscribed, suggesting that similarly structured credits would also appeal to investors.

The total financing included a Eu72 million floating rate construction loan, provided by Zagrebacka, DePfa and Bank Austria. This is designed to provide financial flexibility and reduce the cash drag created by having bond proceeds sit in escrow accounts for long periods of time. Further flexibility is provided through backending the amortization profile, or making it more like a mortgage, so that the government can provide relatively steady payments.

The deal shows that a monoline guarantee is not the definitive answer to emerging market financing needs. If a deal is structured so it can be sold as sovereign risk with a premium, and that government can structure a concession to achieve this small margin, then investors will come running. Even more developed countries could adapt elements of the deal for light rail or tram project financings.

Bina Istra Phase 1B

Status: closed 25 February 2003

Location: Croatia

Description: Combined debt/project bond financing for construction of toll road

Total project cost: Eu390 million

Project bond: Eu210 million

Project debt: Eu72 million

Equity: Eu14 million

Sponsors: Bina Fincom 67% which is in turn 51% Bouygues-owned; Bouygues 16% direct; Croatian Motorways 14.8%; Istarska Autocesta 2.2%

Lead arranger and advisor: UBS Warburg

Subunderwriters: Zagrebacka; DePfa; Bank Austria

Legal counsel to the banks: Allen & Overy

Legal counsel for the sponsor: Bouygues internal counsel

Traffic consultants: Jacobs Gibb