Unconventional Bonds

Bonds know no bounds

A primer on the unconventional financial instruments making waves in emerging markets.

Displaced people gather as the Red Cross in Kano distributes relief materials to displaced victims of the Boko Haram violence, at a relief camp in Dawaki, a local government area in Kano in 2014

Humanitarian Impact Bond

The International Committee of the Red Cross (ICRC) is piloting the world’s first humanitarian impact bond.

The more than USD25-million, five-year bond offers private investors the opportunity to contribute to development in sub-Saharan Africa.
In humanitarian impact bonds, repayment uses a different form of currency—a currency you cannot deposit in any bank.

Dubbed the payment-by-results approach, impact becomes the source of yield for bond investors.
The ICRC is looking to implement this innovative model of financing for a multi-country project in Nigeria, Mali, and the Democratic Republic of Congo (DRC) for the construction and management of three physical rehabilitation centers.

The basic mechanics of a humanitarian impact bond are not too tricky to grasp and involve three parties.
Firstly, project implementers propose a project with a quantifiable outcome. The social investors in the private sector finance this specified outcome upfront, allowing implementers to better plan and more efficiently execute projects rather than relying on annual donations or getting weighed down in excessive amounts of donor reporting.

Enter stage left, risk. The third party, termed the outcome funder, is usually a government institution or non-profit organization, and ends up paying for the actual outcome at the project’s conclusion.
If the project managers come up short so too do the social investors, as the actual funders will only pay for the outcome achieved.

Should the implementers surpass their target, here lies the potential premium for investors. The risk, and on the other side of the coin reward, lies solely with the private sector investors.

At the 2016 UN World Humanitarian Summit in Istanbul, Deputy Prime Minister of Belgium, Alexander De Croo articulated his support for the transformative potential of the new bond, pointing out that it allows the private sector to find new roles and contribute expertise to humanitarian relief beyond the conventional scope of logistics, communications, consulting, or construction.

However, he also warned that the fate of fragile, conflict-weary countries rests in the fragile balance of the arrangement. In order to attract purely financial investors, the return must be aligned with market returns on standard government bonds, which is 1-3%. This means the ICRC and other project implementers need to consistently exceed their targets by the same margin.

De Croo argues that consistently outdoing targets will lead to better calculation of targets, and therefore drive returns to zero, though this may not be problematic for investors that are not solely concerned with financial returns.

It would also incentivize project implementers to falsely lower expected outcomes.

The expansion of the ICRC’s Physical Rehabilitation Program received private financial backing from Lombard Odier’s foundation and New Re of Munich Re. Outcome funders include the governments of Belgium, Switzerland, Italy, the UK, and the Spanish La Caixa Foundation.

According to the ICRC, independent auditors will verify the organization’s reported efficiency in comparison to performance benchmarks at existing centers, hopefully mitigating some of De Croo’s concerns with the scheme.

Social Impact Bond

In addition to the launch of the first humanitarian impact bond, mid-2017 also marked the biggest social bond to date. A social bond gives more structure to the idea of ethical investing, and the social bond market is gaining ground as shifts in attitudes and increased transparency have led people to combine personal views and altruistic preferences with investment.

According to the International Capital Market Association, “Social bonds are any type of bond instrument where the proceeds will be exclusively applied to finance…eligible social projects.” Eligible social projects refer to initiatives that address a specific social issue and/or aim to achieve positive social outcomes.

In June 2017, Nederlandse Waterschapsbank (NWB) of the Netherlands issued a seven-year, USD1.77-billion and a 15-year, USD588-million affordable housing, dual-tranche bond to fund social housing organizations.

The General Manager Treasury at NWB Bank was pleased with result of the bank’s first housing bond, emphasizing that it brought attention to the social housing sector in the Netherlands and gave investors the opportunity to invest in bonds with social impact.

Statistics from Dealogic place the Netherlands at number-one for social bond issuers in 2016 and 2017. The Netherlands is trailed by Spain, France, the US, Australia, Japan, and the Philippines.

Henry Ford, the great American industrialist, asserted that “A business that makes nothing but money is a poor business.” Ford may have been ahead of his time, with the market for social bonds reaching a record high in 2Q2017, peaking at USD3.5 billion.

Green Bonds

Akin to social bonds are green bonds. The green bond market leverages the role of debt markets in financing projects that contribute to environmental sustainability.
Moody’s has forecast that the green bond market will reach USD120 billion in 2017, almost tripling in size from the USD40 billion market of 2015.

On the surface, the explosive growth of the green bond market should make environmentalists ecstatic.

However, much like the “cage free” label on eggs, “green bond” is a label that can be self-applied by issuers and is not always an entirely truthful moniker.

The questioning of green bonds was prompted by Poland’s issuance of a green sovereign bond in 2016, becoming the first country to do so.

A flurry of assessment and evaluation efforts followed, such as certification initiatives and the creation of green bond indices, but suggestions of official attempts to stifle the wind sector in favor of the coal industry have emerged, placing pressure on the government to explain.

Despite the need for increased transparency and assessment, the UK’s largest bank, HSBC, has reason to believe that green bonds will soon outperform conventional bonds due to their high resale value on the secondary market.

Part of this demand increase is fueled by the UN’s Principles for Responsible Investment (PRIs), an initiative designed to encourage investors to consider the holistic implications—environmental, social, and governmental—of their investments. Signatories of the PRIs control a total of USD60 trillion.

Also pioneering environmental investment is the National Bank of Abu Dhabi, becoming the first in the MENA region to issue such a bond at USD587 million. The five-year bond is listed on the London Stock Exchange and is approximately 72% larger than the average corporate or government green bonds issued in 2016.

Green Sukuks

Moving east, Malaysia is championing a hybrid green sukuk, harmonizing green and Islamic bonds to the tune of USD1 billion.

The world’s first green sukuk was preceded by efforts from the Malaysia Securities Commission to establish a socially responsible investment (SRI) and green sukuk framework and market in 2014.

In 2016, Malaysia was the largest SRI market in the region when sharia-compliance was included in the calculation by the Global Sustainable Investment Review. The Malaysian International Islamic Financial Center (MIFC) expects increased interest in green sukuks due to the upward trajectories of conventional green bonds and Islamic finance.

As innovators of the green sukuk, Malaysia is also a global leader in channeling Islamic bonds for infrastructure development. Malaysia issues more than 60% of infrastructure sukuks globally.

Green sukuks could be of particular interest to the oil-exporting countries in the MENA region that have embarked on economic and revenue diversification efforts since the plummet and slow rebound of oil prices. Along with Malaysia, the UAE is one of the most active emerging markets in the area of green bonds and among the top Islamic finance markets.

Sukuk Association established the Green Sukuk and Working Party to develop sharia-compliant, environmentally friendly solutions for investment. Eligible assets can include solar, wind, and waste-to-energy plants as well as low carbon building and transport projects—none of which are in short supply in the MENA region.

The World Bank claims that green sukuks represent a major step in bridging the gap between conventional and Islamic financing.

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