Supranational and agency borrowers are natural incubators for nascent bond markets. They have the resources, the mandate and the stability to do the heavy lifting when it comes to getting new products off the ground. As Ralph Sinclair discovers, what they do next in the socially responsible investment bond market will be critical in determining whether SRI bonds become a force for change in the world.
The International Financial Corporation’s $1bn 0.5% May 2016 green bond, which was priced in February, marked something of a watershed moment for the socially responsible investment (SRI) bond market. It was the first benchmark-sized green bond and the first SRI bond of that size since the International Finance Facility for Immunisation’s (IFFIm) pioneering $1bn vaccine bond from 2006.
SRI bonds had until February most often been sold into Japan or Europe in smaller sizes. The IFC’s intention to issue one benchmark green bond a year starting with February’s deal marked the point at which supranational and agency borrowers moved towards regular large scale SRI issuance.
The deal took the product out of the Japanese retail and European markets where it had nested since the mid-2000s and targeted the deep pools of liquidity sitting with US-based SRI funds. But by coming flat to the borrower’s curve, the trade also hauled in mainstream investors looking for a rare chance to buy IFC paper, irrespective of the trade’s SRI credentials.
Now SSA bankers are urging for the SRI bond market to industrialise.
Citi predicts that global real GDP will double in the next 20 years with energy consumption set to triple by 2035. The bank is forecasting global investment in energy to reach $37tr by 2035, of which $16.9tr is set for the power sector. With demographic factors set to put ever more strain on the planet’s resources, there is a clear need to finance climate change projects and technology.
But the benefits to SSA borrowers of muscling up their SRI financing are not only about saving the planet or doing social good with the proceeds. After all, the multilateral development banks (MDBs) exist to promote sustainable development. For many it is part of their founding agreements, statutes and charters, while for others it is a by-product of their everyday financing work.
But by promoting their SRI credentials, SSA borrowers have found a new promotional tool with which to find new investors. That is exactly what happened with the IFC, which targeted SRI funds based in the US with its green bond benchmark and drew enough orders from that group to allocate the entire deal to them. After the battering many SSA credits took during the years of financial crisis, none of them can take market access for granted so any means of broadening their investor base should appeal.
“SSA issuers do not need thematic products to get their funding done so the strategic objective is investor diversification,” says Navindu Katugampola, a vice president on Morgan Stanley’s SSA origination desk in London.
Although broader promotion of an issuer’s SRI credentials is a topic under much discussion among SSA borrowers, it is themed bond issuance that offers them the sharpest and most wieldy marketing tool.
“Green bonds are a natural starting point for investors and issuers alike working to ESG criteria,” says Raymond Seager, head of SSA debt capital markets at Bank of America Merrill Lynch. “They are an understandable product with a tangible SRI benefit and assets on the issuers’ balance sheets. In addition, many SSA issuers have a critical mass of loans to issue the bonds on the back of. This is an ideal place for the market to focus and get up and running.”
Finding common themes
Themed bonds work as a marketing tool because they bring into focus the work that the issuers support as part of their everyday lending.
Depending on the market — from the Japanese market where investors care far more about the SRI story behind a bond than the technicalities of how the proceeds end up financing a particular project, to investors who demand more rigorous levels of ring-fencing and reporting of where their money has gone — green bonds offer varied opportunities depending on just how much a borrower can dedicate in resources to setting them up.
Themed bonds also allow a borrower to drill further into the investor bedrock to find smaller funds looking for a particular niche asset to buy. They may even get to the point where they may find investors looking to help finance specific projects. But in a market aiming for scale, such small tickets are unlikely to appease issuers or investors looking for liquidity and blocks of funding.
“Liquidity is a key concern of investors in any market now. So, the private placements we saw previously in this market are likely to become less common as the markets grow and can offer more liquid product,” says Seager.
One group that has been pushing the idea of green bonds since 2009 is the Climate Bonds Initiative, an investor-focused NGO in London, founded by Sean Kidney.
“We are trying to channel more capital market investment into climate change mitigation and adaptation outcomes,” says Padraig Oliver, research manager at the Climate Bonds Initiative in London. “We want to bring issuers and investors closer together, raise awareness of how bonds could facilitate the investment needed for the transition and conduct research into issues like how to derisk structures and make them investable.”
But themed bonds may not offer the route to industrialisation many participants in the SRI market are hoping for. For a start, by focusing on particular issues, they risk not engaging the maximum number of investors. Ethical investors have interests ranging far and wide from those with say, a religion-based set of investment cirteria, to those focused on particular SRI issues. The narrower a bond’s focus, the less likely it is to reach the maximum number of investors.
Then there is the limited number of borrowers that have an asset base big enough to support benchmark-sized borrowing. For titans such as the European Investment Bank and the IFC who pour billions of dollars worth of financing into SRI projects, there is the scope to match liabilities and assets on a large scale. But for smaller borrowers, they often cannot pull enough assets together or find sufficient projects to support to justify a full benchmark-sized deal, much less to justify any of the costs involved in getting the SRI features of the deal certified independently, ring-fencing the proceeds, marketing the product, and reporting to investors how each project is progressing once the deal has been priced.
This is especially true for issuers such as municipal funding agencies and export guarantee issuers. Their entire funding programmes often only justify a couple of benchmarks deals a year. By the time they have rooted out the projects that would qualify for a themed deal, they may barely need enough funding to justify a medium term note, let alone a public syndication.
Even borrowers such as the World Bank, which has raised over $4bn equivalent through almost 60 green bond deals sold mostly into Japan and notably into the World Bank Green Bond Fund set up in conjunction with Nikko Asset Management, and the European Investment Bank have yet to take the plunge with something as big as $1bn in one go.
In August, the World Bank issued a $550m two year green bond through Morgan Stanley and SEB. The trade attracted 17 investors and was syndicated as a club deal rather than a full benchmark pricing meaning the borrower targeted a small number of accounts focused on SRI bonds. That helped it avoid the allocation problem faced by the IFC in February when Asian central bank orders demanding generous allocations muscled in on the SRI interest.
The EIB took a similar approach to a Climate Awareness Bond denominated in euros issued in July. Although the deal now stands at €900m, the 1.375% November 2019 deal lead by Bank of America Merrill Lynch, Crédit Agricole, DZ Bank and UniCredit was originally a €650m print with the remainder added on at the start of September by the original leads joined by LBBW and SEB.
Another dilemma facing themed bond advocates is the question of their very definition. A recent white paper on green bonds published by Citi and BAML (see page 80) shows that the Organisation for Economic Development and Co-operation, the World Bank, the IFC, the EIB and the Climate Bonds Initiative have all published hefty draft or final taxonomies that aim to define and categorise the green bond universe.
Each version has its own idiosyncrasies and methodologies and each is lengthy and complicated. While it should not be lost on anybody with an interest in the SRI market that it is still in its infancy and will require time and effort to whittle down a more practical approach, it is encouraging that so many bodies are looking at the matter in that much depth. But with so much variation and detail surrounding the SRI value of the underlying credit’s business, and how deal proceeds are used, it is hard to see the market achieving exponential growth while classifications merely replicate the complexity.
“It has been a difficult process to assess what to put in and what to leave out,” says Bridget Boulle, programme manager at the Climate Bonds Initiative about its own taxonomy. “We have had to err on the side of being rigorous — we do not want to add to greenwash, because there is a lot of it.”
Keep it simple
Such complexity in any market will also deter mainstream investors and other classes of issuer — precisely the sort of constituents required to build the SRI bond market’s wholesale credentials. Large scale investment managers and corporate treasurers looking to issue SRI products will be swiftly deterred by anything that hinders the swift and efficient means of making investments or raising capital.
“In the long run common methodologies applied across the issuer universe would be helpful,” says Katugampola. “We must avoid having accreditation turn into a bottleneck to issuance.”
That would suggest a simplified approach to the SRI market would help it grow. One way of doing this favoured by a number of SSA borrowers is rather than rely upon themed bond issuance with all its complexities, to gather third party reviews of an organisation’s entire ESG criteria.
This is appealing to supranationals and agencies because they should naturally score highly on this front by dint of their very purpose. It also provides a way, when it comes to investors that assess a borrower’s full operation on ESG grounds before investing, for the supranationals and agencies to avoid dealing with myriad and often impractical questionnaires about how they operate as institutions. Borrowers have reported receiving tens of questionnaires assessing hundreds of separate criteria with one making the point that it was not an efficient use of their time finding out what the water recycling rate was in the institution’s Mongolia office for the sake of one bond sale.
There are a number of fledgling third party providers of ratings and accreditation for ESG and green credentials, but no recognised market leader. There is also no single governing set of criteria on which there is a consensus on how issuers should be judged. For those hoping that something as straight forward as a credit rating equivalent would emerge for the SRI bond market, they may be in for a long wait as market participants wrangle with the complexities that riddle SRI capital markets.
“To use the word rating draws comparison with credit ratings, but a credit rating measures only one dimension — the probability of timely payment in the appropriate volume,” says KfW’s head of financial markets, Frank Czichowski.
“A standard SRI rating today means you are probably talking about something like 100 or 120 dimensions to the rating and everybody… probably has a different view on which of these 100 dimensions is the more important one.
“We have to come up with a more standardised approach of how we judge which of the many dimensions are more important than others.”
An overall issuer rating would make for easier comparisons between borrowers and would, by setting a common criteria, be a good way to raise standards throughout the borrower universe by setting out what the best practice is.
But investors, bankers and borrowers alike warn against the limitations of what overall ratings can prove. For instance, a borrower such as Rentenbank, which finances end users via intermediary banks, is not in a position to know how exactly every last euro it lends is used.
“[Issuer ratings] have to be taken with a pinch of salt because sometimes we simply cannot answer the questions asked in such detail because we are typically not directly lending to end-borrowers, but we are by law and statutes forced to use intermediating banks,” says Rentenbank’s head of treasury, Stefan Goebel. “We have limited control over the information they drum up from the end borrowers unless we want to overburden on the lending process to the extent that local intermediary banks will find it unaffordable to offer loans from our lending programmes.”
Many investors, while seeing an issuer rating as a useful addition, would much rather rely upon their own due diligence work on a borrower and certainly would not be willing to pay for a third party rating. After all, a number of investors such as Generation Investment Management and Standard Life have had ethical funds or SRI approaches to investing for many years and any attempt underway to rate issuers according to ESG criteria en masse will only be playing catch-up to these firms’ own proprietary approaches.
There is also the risk of oversimplifying the rating to the point where it becomes so easily achievable that it becomes meaningless and negates the very reason for having it in the first place.
Instead, bankers and investors clamour for greater transparency. Investors in particular are keen to see where their money will end up. “Investors like to see from issuers the end product,” says Stuart Kinnersley, CIO at Nikko Asset Management Europe. “A project list is invaluable in terms of providing transparency with methodical reviews and updates.”
“Our investors are asking not only for information on the projects themselves but on the progress and the development of these projects,” says Carlos Perezgrovas, executive director, SSA origination at Daiwa Capital Markets. “They want to be updated on a regular basis about what’s going on at a particular wind farm or thermoelectrical power plant or water treatment plant.”
That extra transparency, while demanding resources from borrowers, will be rewarded say bankers, with long term investment. “The stickiness of the money that goes into green bonds is higher and in volatile markets you will see a tendency for outperformance in those assets,” says SEB’s head of sustainable products and product development, Christopher Flensborg.
Even if those issues of transparency and common methodologies were to be overcome, in terms of market scale there is no guarantee that benchmark deals would become the norm from SSA borrowers. The fact that there has as yet been only one benchmark-sized green bond testifies to that lack of both demand and supply.
“Investors see $500m as a relevant deal size,” says Morgan Stanley’s Katugampola. “The incremental benefits of bigger deal sizes are not something they are demanding.”
“There are some caps on the benchmark-sized market within SSA given the finite numbers of borrowers that have a big enough asset base,” says BAML’s Seager. “I think we will trend towards deals of $250m at least though, because they are then index-eligible which is important to many investors.”
Important to progress
But there are several good reasons why the supranational and agency group of borrowers must continue to drive development of the SRI bond market. Their mandate to provide sustainable development makes them the least conflicted group when tackling the costs and complexities of getting to grips with this market. They have much deeper pockets than corporates for taking on the sort of work demanded and less pressure to maximise profits for shareholders than borrowers in other asset classes.
Furthermore, their development missions and their insensitivity to credit risk makes them the ideal borrowers to get new markets underway. They are the most experienced borrower group at doing this work, from the World Bank’s pioneering work with the global bond format, to other supranational and agency attempts to start local currency markets in emerging markets, or even the IFC’s latest SRI bond innovation — the gender bond, which will provide funding for female-owned businesses in Africa.
But what the supranationals and agencies that are working together and individually do next will determine the success of the SRI bond market for years to come. They will benefit from the extra investor cash that comes their way as they promote their own SRI credentials. But the SRI bond market could and should grow to encourage borrowers from other asset classes — corporate issuers in particular — to bring their own SRI bonds.
The complexities and diversity of issuer and investor needs are vast but to boil them down too far would render any SRI designation meaningless. If intermediaries are allowed to commoditise the market simply to allow them to churn deal fees by pumping out what are effectively regular bonds given a coat of greenwash then the investors not already disenfranchised by not having their needs specific SRI met will grow cynical of it.
Similarly, for the market to achieve its potential as a means of funding SRI projects, for helping supranational and agency borrowers achieve their highest SRI potential as institutions, and as a means for borrowers from a range of asset classes being able to access the broadest pool of capital possible, then they cannot become mired in thickets of competing taxonomies, or over-onerous investor assurance and reporting processes.
If the market really is at an inflection point, as a number of senior SSA bankers believe, then there is a compelling case for SSA issuers and investors interested in SRI products to work together to find the most suitable common ground quickly.
| IFFIm makes a difference|
The International Finance Facility for Immunisation (IFFIm) made a big splash in bond markets back in 2006 when it brought a $1bn vaccine bond. By the time it returned to the public dollar bond market in June 2013, that original deal had long since matured. But from the investor reception its comeback received, it was clear bond buyers were more than happy to welcome it back.
“[We] did a lot of investor work to try to market the name and cause among specific ethical investors that could have been interested in this transaction,” says Carlos Perezgrovas, executive director, SSA origination at Daiwa Capital Markets in London, which lead managed the sale of IFFIm’s $700m three year FRN with Deutsche Bank.
“And although we also targeted traditional SSA investors during the marketing, it was only until the bookbuilding process advanced that it became clear that we could face an allocation problem.”
Both ethical investors and central banks piled into the order book for the deal alongside other institutions keen to buy a bond that finances humanitarian work, forcing IFFIm to raise the deal size from its planned $500m.
IFFIm is a vehicle that uses donations from governments to back vaccine bonds. The proceeds of the vaccine bonds that it issues are used to provide immediate funds for the GAVI Alliance, which works to increase access to child immunisations in poor countries.
The governments of the UK, France, Italy, Norway, Australia, Spain, the Netherlands, Sweden, Brazil and South Africa have pledged more than $6.3bn over a 23 year period. IFFIm has raised $4.5bn of bond market funding to date, which is more than six times the donor funds received so far boosting the GAVI Alliance’s ability to provide vaccinations.
An independent report published in June 2011 said that IFFIm’s funding would have helped the GAVI Alliance to save an estimated 2.1m lives by that point.
In between its two appearances in the public dollar market, IFFIm has gone the way of many a supranational or agency borrower with a high credit rating, a small borrowing programme and a socially responsible investment story to tell by raising capital from the Uridashi market.
Using the World Bank as its treasury manager has allowed IFFIm to issue Uridashi bonds in a range of currencies since it first tapped that market in 2008. It was a pioneering deal in helping to establish the trend for buying SRI bonds in the country.
Since then it has issued bonds in Australian dollars, Brazillian reais, New Zealand dollars, Turkish lira and South African rand into the market.
It also issued a £250m 3.375% May 2014 sterling bond in 2009.