How Can Drawdown Loans Help Save Money When Financing Projects?
Project construction can take multiple years to complete and is often executed on an unpredictable schedule.
When projects are financed by issuing bonds, it can be inefficient to receive all the proceeds upfront since spending the money will likely occur over time. In general, issuers lose money until bond proceeds are spent because the borrowing rate on the money is greater than the investment rate (also known as negative arbitrage).
Drawdown loans eliminate the need to reinvest the money until used, thus eliminating the potential loss of money between the borrowing rate and the reinvestment rate.
Example:
A city might need $30 million total for a project. It could borrow the total amount needed with bonds, but it would have to invest any unused proceeds until the money is needed for the project. The new investment might earn a lower rate than the city’s bond’s rate, losing money.
Instead, the city could enter into a drawdown loan and borrow $30 million over time. This helps the city to eliminate the potential reinvestment loss and minimize interest payments because the entire loan amount of $30 million was not borrowed on day one of the financing. Further, the city won’t have to pay interest on the $30 million until the money is drawn.
What’s important here?
The original size of the drawdown loan is the amount the borrower requires on the date of closure of the loan. As additional money is needed to fund projects, the loan size is increased by the additional need. The loan size continues to grow over time until the project is fully funded. The borrower can also usually increase the size of the loan over time with the interest payments due to the bank. This eliminates any out-of-pocket interest expense the issuer would have had to pay the bank before the money is spent.
After completing the project, the borrower can continue to keep the loan in place if they’d like. However, the loan rate usually increases after the construction period. Therefore, the borrower usually refinances the loan with long-term bonds when a project is finished.
