Creative tension set to shake up MDB financing
An unvarying supply of senior bonds has been the multilateral development banks’ contribution to capital markets for many years. As Jon Hay reports, that is about to change. As they strive to optimise their balance sheets, risk sharing will proliferate and the first hybrid capital issues should appear. There may even be public equity issuance. If all these techniques work, they will also trigger a big increase in senior bond sales.
Multilateral development banks’ bonds are the plainest of plain vanilla. Most large ones have been rated triple-A for decades. Year after year, they pump out tightly priced paper, scratching to save the last basis point, to pass on the lowest possible cost of funds to their developing world borrowers.
But little by little, the sector’s capital markets output is becoming more diverse. On one side, some of the MDBs are trying to find ways to lend more. On the other, their national government shareholders are urging them to do more with the resources they have.
Using financial engineering to boost capital capacity is an area where MDBs have succeeded in innovating in the past decade, although patchily. Now, as part of a much wider push for reform (see separate article), there is likely to be a flourishing of new structures.
Perhaps surprisingly, it will not begin with the largest and grandest institutions, but at the sector’s periphery.
The layperson might assume that, since development needs are vast and MDBs have limited capital, the MDBs must always be operating at the maximum of what they can do with their capital.
In fact, this is not the case. Much of the time, many of the MDBs are not capital-constrained, and have therefore not needed new ways to make their capital go further. Hotspots of innovation have tended to occur when MDBs were feeling the pinch.
The African MDBs, which are confronted daily by some of the world’s most urgent development needs, have been particularly creative in devising new instruments to get the most benefit from their capital.
After a push by the G20 in 2015, amid a climate of post-financial crisis austerity that made it hard for the MDBs to obtain more capital from their shareholders, a smattering of balance sheet optimisation deals was done in the mid-2010s.
They included a $4.5bn triangular sovereign exposure swap between the World Bank, African Development Bank and Inter-American Development Bank in 2015 and the Asian Development Bank’s merger with its concessional arm in 2017, which effectively tripled its capital.
The African Development Bank, which was fast running through its 2010 capital increase and was not due for another till 2020, went furthest, with its Room2Run programme. It included a $1bn securitization with private investors — the first of any size by an MDB — and a $500m insurance transaction, both in 2018. Between them, the deals freed up capacity for $1.1bn of fresh loans.
Hopes that a rash of such transactions would follow were quashed by the Trump administration’s hostility to financial engineering, the shock of Covid and perceptions — still prevalent among MDBs — that the view that AfDB’s securitization had been expensive.
The bank paid a 10.625% coupon on the $152.5m mezzanine slice of risk transferred to an arm of US hedge fund Mariner (now Newmarket Capital) and Africa50, an infrastructure investor backed by African governments.
“I don’t think people understand the mathematics,” says Tim Turner, who was AfDB’s chief risk officer at the time. “The coupon worked out to about 42% of the margin AfDB was earning [on the whole loan portfolio]. That premium allowed us to get a more than 65% reduction in capital, so there was 1.5 times more benefit than cost.”
The insurance deal, on a vertical slice of a portfolio, consumed about 60% of its margin but achieved 90% capital relief — the same 1.5 ratio.
Because of that, “We were able to negotiate on both sides to drive the prices down,” says Turner.
The securitization was also in line with pricing for equivalent risk transfer deals by commercial banks, supporters believe.
Now, the political and intellectual climate among MDBs is supportive of financial innovation again, and the African institutions are leading the way.
After at least four years of work, the AfDB completed in October the third leg of Room2Run, achieving almost complete capital relief on $2bn of sovereign loans for 10 years, amortising until year 15. Three insurance companies are taking $400m of first loss risk, the UK government the $1.6bn top slice.
Shedding the risk on sovereign assets is harder than on private sector loans because they yield much less and investors could often buy the countries’ risk in the bond market if they wanted to.
The actual risk involved is arguably quite small. The AfDB only lends to 17 of the most creditworthy countries in Africa, and since 1995 none of them has defaulted.
But the capital relief is extremely valuable — the AfDB will be able to do up to $2bn of fresh climate projects.
Unfortunately, just when they were about to start motoring with innovative capital deals, the MDBs have had to jam on the brakes to avoid the dire capital markets conditions of 2022, with searing rises in interest rates.
In May, a new era appeared to be beginning when Banque Ouest-Africaine de Développement, the development bank of the West African Economic and Monetary Union, began marketing to investors a $500m deal that would have been the first hybrid capital bond from an MDB.
Although some MDBs have subordinated loans, they are limited, private instruments. Just as the MDBs lack the advantage commercial banks have of being able to issue equity at will, they have also had no access to the public market for hybrid capital.
Being able to issue notes that the rating agencies explicitly agreed to treat as equity could be an enormous boon to the more capital-constrained MDBs.
Criteria changes of different kinds by all three major rating agencies had removed some of the obstacles to MDB hybrids.
BOAD’s 60.75 year, non-call 5.75 deal was to have been rated Ba1 by Moody’s, three notches below its Baa1 senior rating, which was on review for downgrade because of unrest in Mali. Moody’s was going to give it 75% equity credit. BOAD is rated BBB by Fitch.
However, amid a bearish market for emerging market bonds, the deal was postponed.
BOAD’s rating has since been stabilised by a combination of an improvement in the situation in Mali and Burkina Faso and a capital increase, including the entry of new shareholders.
Plans on hold
The Eastern and Southern African Trade & Development Bank, known as TDB, had hoped to bring its first hybrid to market even before BOAD’s, but had been put off by market conditions.
The deal was ready in early 2022, but “Sadly, the bank missed its window,” says Turner, now a senior adviser to TDB in Nairobi. “The Fed started raising rates, then that market just died.”
Because perpetual hybrids are sold with call options, and their coupons reset if they are not called, they can become unattractive to investors when interest rates are rising fast, because the issuer’s incentive to call can evaporate, if the reset rate ends up being lower than prevailing market rates.
Turner thinks that market will be closed until interest rates stabilise.
He remains enthusiastic about it, though. “Fitch had confirmed that if we did a large enough deal, it would boost our capital ratio and we would get upgraded,” he says.
TDB is rated Baa3/BB+, so flipping the Fitch rating to investment grade could have saved it 15bp-30bp on its senior debt spreads, banks had advised it. That might even have enabled it to recoup the cost of the hybrid within a year.
“It was much cheaper than for us to issue new equity,” says Turner. “TDB has been producing a return on equity in excess of 10% for almost a decade, and this would have been 6% to 7%, given where rates were.”
Seeking the right price
The AfDB is determined to issue a hybrid too, which it could leverage with senior debt to issue new loans of three or four times the hybrid’s size.
S&P noted in February that the bank had had to decrease its disbursements “due to capital constraints”, though it expected loan growth to pick up in 2022.
After 18 months of work with the rating agencies, the AfDB has designed a structure that will get it 100% equity credit from at least S&P and Fitch. It has been approved by the board.
What remains is to bring it to market. Hassatou N’Sele, the bank’s chief financial officer, is in no hurry. Not only are market conditions less than perfect — she is anxious to ensure that investors do not just apply pricing methodologies copied from the financial institutions or corporate hybrid markets. The AfDB will hold extensive roadshows next year, to help investors give full credit to the strength of its balance sheet and business model.
The AfDB has defined what triggers would cause the hybrid to take losses. These have to be “plausible and remote,” N’Sele told GlobalCapital in October. “But just because of the way we are structured as an institution, and based on our solid risk management framework, the instrument is not expected to get to that level. Because internally we have all the buffers and as a multilateral development bank, we have benefited from extraordinary shareholder support. In my view when investors understand the MDB model they will be able to price it.”
The AfDB receives a capital increase every 10 years and its risk appetite statement requires it to remain triple-A rated. If its ratios appear threatened, it can adjust its lending, and if there was a crisis, it could also ask shareholders for support.
In BOAD’s structure, the issuer can choose to stop interest payments at any time and must do so if its equity falls below 18% of assets.
To maximise equity credit, on all three of these planned deals any missed coupon payments will be missed permanently.
Not so outlandish
The idea of the World Bank, International Finance Corp or European Investment Bank becoming a regular issuer of hybrid capital sounds outlandish now. But commercial bank and corporate hybrids were once new-fangled, too.
If the AfDB, a triple-A rated institution whose major shareholders include countries such as the US, Japan, Germany and France — leading participants in many MDBs — can bring a deal to market successfully next year, there would be no reason for the Washington and European-based institutions not to consider it.
An even more futuristic step is being prepared at TDB. The bank is preparing a project to float shares on the stock market — and not just any shares, but green equity. For each dollar raised, TDB would promise to invest $4 in green projects.
As long ago as 2012, TDB brought in institutional investors as shareholders, alongside the 22 national member states. There are now 17 of these class ‘B’ shareholders, which have joined through a private membership process. They include official institutions like the African Development Bank, but also pension funds from countries including Tanzania, Uganda, Rwanda and Mauritius.
“We have been gradually increasing the portion of commercial capital, which we think is a great thing,” says Turner. Class ‘B’ now accounts for nearly 30% of paid-in capital. “The money coming in from the private sector is great, but the impact on governance is at least as important. It forced us to change our board structure, with seats for representatives of the private sector, including independents. It’s created a much more balanced discussion — still focused on development, but also the commercial side. Everything has to meet a dual lens. It’s a hugely positive thing for TDB.”
To allay concerns that too much private involvement could dilute TDB’s development focus, the new green class ‘C’ shares it is planning will be non-voting.
The first tranche, ‘C1’, will be placed privately. Two investors are on board: the AfDB with $15m and the donor-backed Clean Technology Fund. By late next year, TDB hopes to have gathered $50m-$100m.
In the meantime, TDB is exploring the pros and cons of a potential listed version, class ‘C2’, open to any private investor. If approved, it might go ahead at the end of 2023. One option could be to list the shares in Nairobi and London.
The bank has held discussions with the UK Foreign, Commonwealth and Development Office, which has a programme called Mobilist, which invests in and provides technical assistance for new listed products in developing countries.
“We think it can fundamentally change the way development finance institutions mobilise capital,” says Turner. “MDBs typically do a general capital increase, which is horrendously disruptive. It takes two years to negotiate and there are quid pro quos from each government. The MDBs go from being undercapitalised at the end of the cycle to overcapitalised. They are then awash in surplus capital and look incredibly inefficient.”
The long term goal of issuing equity to private investors, Turner says, is to give TDB access to equity and hybrid capital that it can tap as needed, like a commercial institution, to keep its capital at the right level to support its credit ratings and maintain a strong return on equity for its shareholders.
“There is some nervousness [among TDB’s management] about where is the pipeline of green projects that we can use to meet that commitment, and what happens if we don’t make it,” says Turner. “The big DFIs which are awash with concessional money are flooding the market, so there are very few deals left which are attractive for TDB.”
TDB is an entrepreneurial organisation which lends at commercial rates. Institutions like the European Investment Bank, European Bank for Reconstruction and Development Bank and Agence Française de Développement, on the other hand, have pools of money for climate finance, Turner says, “but use it in a way that makes it less attractive for commercial players to participate in that sector.”
Despite that, he believes it is worth going ahead. “The institution is committed to greening its activities,” he says. “Our region is developing, but it has to transition.” GC