MDBs are under pressure to maximise their lending capacity and attract the private sector to help finance it. Two strategies have emerged for raising additional capital from hybrid securities without affecting treasured Triple A ratings. By Nick Herbert.
In January 2024, the African Development Bank issued the first hybrid bond from a supranational in the public markets. The AfDB’s US$750m perpetual non-call 10.5-year, issued as a sustainable bond, finally appeared following the announcement of plans to do so earlier in 2023 and completion of investor presentations in September of that year.
The World Bank, meanwhile, chose a 'friends and family' route for its hybrid capital experiment, raising US$750m from its shareholders.
"We’ll be watching the progress of these deals with interest,” said Jens Hellerup, head of funding at Nordic Investment Bank. "If you can’t increase your baseline capital, then issuing something like hybrids make sense for a borrower. But is has to be at a spread attractive to investors. And then there’s the big issue: the cost."
Hybrid issuance comes as a result of the increased pressure being placed on multilateral development banks from their shareholders to lend more at a time when many countries are experiencing increased fiscal pressure and the world is falling behind in meeting mission-critical global policy objectives.
Shareholders have been pushing MDBs to innovate in an attempt to draw in more private capital and optimise their balance sheets to increase lending operations. The demands on MDBs to do more with their capital are nothing new, but the pressure has mounted in the wake of recommendations emanating from the G-20 independent panel on MDBs' capital adequacy frameworks.
Recommendations include finding ways of incorporating callable capital into capital adequacy metrics, the greater use of guarantees, exploration of risk transfer options to the private sector and among peers, the issuance of hybrid capital to the private sector and shareholders, and the wider use of special drawing rights.
A major problem for MDBs throughout this process, however, is for any capital optimisation ideas to be achieved without the banks’ Triple A ratings being jeopardised. Any deterioration in credit ratings has negative implications for their institutions.
"The way MDBs work is that at whatever cost we raise debt in the markets gets passed through to our loan book," said George Richardson, director of capital markets and investments at the World Bank Treasury. "Any addition to funding cost gets paid for by our borrowers."
Passing through any additional costs to borrowers is a major bone of contention.
Examples of market-led solutions satisfying the challenge of providing MDBs with greater levels of finance without stressing top-tier ratings already exist – AfDB, for one, closed a synthetic portfolio securitisation in 2018. But any solutions put forward also have limitations.
"They are all bright ideas and, in aggregate, all have value," said Lee Cumbes, head of DCM at Barclays. "One area that we know has significant, well-tested potential in size and scale is the hybrid market."
If the product is embraced by investors, in theory the MDB’s have the potential to raise over US$100bn.
Reaching that kind of scale, however, will only be realised if the AfDB’s deal represents the first of many more, as opposed to a one-off. The AfDB says it wants to tap the market again and other MDBs are said to be in the pipeline, but not everybody is convinced of the deal’s success or the structure being appropriate for MDBs as a means of tapping into the pool of private finance.
Balancing act
The fundamental problem for some MDBs is the additional cost above and beyond Triple A funding costs. They on-lend to their private and public sector clients at the cheapest rate possible, so an additional basis point on MDB lending rates is anathema.
Investors, on the other hand, demand a yield pick-up on hybrid deals to reflect the risks inherent in the product.
"Private investors – while they may be interested in contributing to the sustainable development cause, also want returns,” said Alexander Ekbom, managing director, sector lead MLI & PSFA at S&P. “There's very little private philanthropic money out there to invest in these instruments."
The AfDB deal was priced to yield a pick-up of 135bp over the borrower’s senior curve, from initial marketing at 200bp over.
The counter-argument to MDBs paying more for capital than on senior notes is that it enables greater levels of lending. In the case of the AfDB deal, the leverage on hybrid capital is calculated at a three-times multiple. In terms of costs, the additional impact of paying higher coupons on any one hybrid deal – measured against the issuer’s entire lending portfolio, is marginal, "and can be within the range of market volatility from issuing senior debt", said Cumbes.
Friends and family
Meanwhile, by mid-June, the World Bank had raised a total of around US$950m from its own shareholders as 'first movers' through private transactions.
"We’ve looked at issuing a public bond but thought there must be a way of raising hybrid capital far more effectively and cheaply by focusing on our shareholders," said Richardson.
Most MDB shareholders are not interested in the financial returns from investing in MDB hybrid capital – they already provide equity capital for free without receiving financial dividend payments – they are more interested in the impact that can be derived from the leverage it provides.
"[The transactions] can be seen as being similar to a pre-capital increase for those that care," said Richardson. "Like a pre-funding of some future capital increase."
In this case, the World Bank calculates lending additionality of eight times per dollar invested over a period of 10 years – and in some cases more, depending on what participating shareholders choose to do with the coupons.
"We came up with the idea of 'preferencing', now called the Global Solutions Accelerator Platform, which is part of a so-called 'Financial Framework for Incentives', allowing the shareholder to steer the bank’s future lending to global challenges with the capital it invests today." said Richardson. "That gives the donor the ability to connect with a desired impact."
Shareholders can invest coupons, which are calculated at the "average funding cost of the Triple A portfolio of bonds that we've issued", into any of the World Bank’s trust funds or back into the IBRD’s net income. If the shareholder chooses to return the coupon to IBRD, the amount of lending capacity increases to 10 times over 10 years.
The transactions also come with a put option, which presents shareholders with the choice to redeem securities at a specified point in the future to help pay for subscribed capital in any future capital increase, or decide to leave it in place as a permanent investment.
"[Shareholders] very much welcomed that innovation because it gave them the flexibility to go through their normal processes for a capital increase, but to do it today, ahead of time, and not have that effort wasted," said Richardson.
Fit for purpose
The risk of a publicly issued hybrid bond becoming a perpetual security also provoked discussion, with some questioning whether the extension risk in the structure makes this product an appropriate vehicle for a private hybrid investor.
Hybrids have long been used by commercial banks and corporates to optimise their capital structure, with the equity-like debt instruments counting as equity on the balance sheet but cheaper to issue. Nevertheless, debt investors do not typically buy perpetual securities. That is the remit of equity investors.
Hybrid bonds in the public market are structured with a call option – an option that in most cases is triggered by borrowers – and notes are priced to that call to reflect the likelihood of early redemption. There are also options to defer coupon payments, convert the instrument into equity or, in extreme cases, write it down completely.
The likelihood of a call being exercised reflects the health and profitability of the borrower as well as the underlying interest rate environment, and that drives the price of the security.
So, what determines the price of a hybrid issued by an institution that is not driven by profit maximisation? Especially a deal that opens a new market and one with no direct comparables.
"As the first of its kind, we were working from a blank sheet of paper,” said Thomas Flichy, Barclays’ head of global finance solutions. "That is why AfDB met with so many investors, to better introduce the product.
"Hybrids are widely understood within the investment community, as banks, corporates and insurance companies are regular issuers of this type of security. So, reference points exist but there are virtually no hybrids issued by financial or non-FI corporate issuers as highly rated as AfDB's." AfDB's deal is rated Aa3/AA– by Moody's/S&P.
Target audience
Critics point to the performance of the bond following launch as an indication that the investor base for an MDB hybrid is not yet established and that paper was mostly placed with credit hedge funds, attracted into the deal as the fixed-income market rallied hard at the turn of the year.
The AfDB deal was quoted at a price of around 95–96 with one of the leads in early June from the launch of 100, in contrast with a bank AT1 market that has performed well.
The universe of buyers for MDB debt mainly consists of central banks, bank treasuries and sovereign wealth funds attracted by the zero risk weighting. The investor base for 100% risk-weighted hybrid capital is very different.
"When it comes to hybrids, you have bespoke investors, and they are usually different to those investing in senior unsecured bonds because of mandates et cetera," said Ekbom.
"Before this deal, there were typically two sets of hybrid investors: one not willing to take a writedown on conversion risk – investors in the corporate segment where borrowers can stop coupons but securities cannot be written down; and then you have those that take bank paper, where they are willing to take writedown or conversion risk. But then they want higher premiums."
But, with the development of any market, it takes time to establish an investor base and for investment mandates to change to accommodate a new instrument.
"It took a while for corporate hybrids to establish themselves in the market approximately two decades ago," said Flichy. "And, similarly, it took some time for the new-style bank AT1 market to see the light in the aftermath of the 2008 global financial crisis and grow to what it is now, a triple-digit billion dollar market."
Both examples of MDBs issuing hybrid capital have pros and cons and there are payoffs: attracting private finance at a cost, or minimising costs at the expense of drawing in private investors. There are sure to be further attempts at finding the right balance.
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