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Emerging Markets

Climate-resilient debt — bring it on

Barbados hurricane church from Alamy 10Nov22 575x375

Bonds with built-in payment breaks for disaster could be safer and more valuable

Much of what gets hailed as innovation in financial markets is either trivial — such as pandemic response bonds — or actively harmful. Let's think CDO-squareds and give cryptocurrencies a breather this time — they’re ruining their own reputation this week.

Occasionally an innovation is devised that genuinely increases the sum of human happiness. The International Finance Facility for Immunisation is one. Using the principle of securitization, it turns donations that will dribble in over years into upfront cash.

Climate-resilient debt clauses could be another.

This week a panel of capital markets aristocrats including the International Monetary Fund, World Bank, International Capital Market Association and the UK government put forward a model term sheet for such clauses.

They call for them to be widely adopted by nations that are increasingly vulnerable to climate shocks, especially small islands and less developed countries.

The group suggests a list of 103 states that ranges from Afghanistan to Zambia, but also includes some surprise rich nations like Singapore and large ones like Indonesia.

Bonds with these clauses would, if a disaster of a predefined, measurable magnitude occurred, give the borrower an immediate debt service holiday of, say, two years. Deferred interest would be paid later.

Bright ideas have been proposed before to improve on tried and tested structures developed by markets. GDP-linked sovereign bonds, with payouts that vary according to a country’s economic health, are a classic example.

Bond professionals scorn these as idealistic codswallop. Investors already assess and price sovereign credit risk. Why make it more complicated by introducing fiddly steps into the bond structure? The result would just be to raise the cost of debt.

Investors should not dismiss climate-resilient debt clauses, however. If used by resilient countries, they could face the same criticism as GDP-linked bonds: making a bad situation for a country worse.

But for states where a climate disaster can be genuinely catastrophic, threatening the government’s ability to service debt, CRDCs could be a blessing.

When lending to such countries, investors are on the hook for the risk of hurricanes, earthquakes and pandemics anyway, whether they like it or not.

Taking payment interruption in a calm, legally ordained, foreseeable way is infinitely preferable for both sides to the ugly brawl of a debt restructuring negotiation.

Even if the country could have carried on servicing debt without the holiday, granting it one is certain to make life easier for the government and give it a better chance of rebounding economically.

Recognising that climate risk is now a central fact of economic life, especially in the developing world, which is only likely to get worse and will require financial system change, is in itself profoundly salutary.

There could be some legal wrinkles to iron out, such as how CRDC bonds stand relative to ordinary ones in a restructuring.

But assuming that can be done, CRDCs are a creative idea that appears thoroughly benign. Investors should embrace them — in fact, demand them.