With its development of outcome bonds, the World Bank is responding to requests from its investors for a more direct link to identifiable sustainability projects. Scaling the product and project outcomes is the next challenge. By Nick Herbert.
Many bond investors face a dilemma. They need to conform to cautious fund mandates that might limit exposure to credit risk while also wanting to satisfy the growing momentum for investment to be channelled towards sustainability. And not just ‘sustainability’ in a general sense but to specific projects where they can say ‘look, we funded this directly’.
It is a dilemma that the World Bank is addressing with its outcome bonds.
“The outcome bond structure came about in response to our investors wanting a direct link to a specific project or programme,” said Michael Bennett, head of market solutions and structured finance. “We wanted to create a product that gave investors that link to funding a project but, at the same time, had attributes of a World Bank bond they were familiar with.”
Outcome bonds are unlike the more common use-of-proceeds or sustainability-linked bonds in the world of sustainable finance, products where investors take exposure to the issuer carrying out the project activities.
“These [outcome bonds] are quite different because we can use the structure to direct funding to projects that are aligned to the World Bank’s priorities and are not financed by World Bank lending,” said Bennett.
Since the World Bank first issued bonds in 1947, its notes have proved an effective conduit for directing public and private investment into funding much-needed development projects. That base-line objective has more recently been superseded by the requirement for proceeds of all bonds it issues to support the financing of sustainable development projects and programmes designed to achieve positive social and environmental impact.
The bank supports the cause by pooling funds raised from its sustainable development bonds. Pooling the proceeds from its bonds means that while SDBs ‘provide investors with an opportunity to do well by doing good’, there is no specific link between a bond investment and the support for any particular project.
“What bond investors get with a typical World Bank bond is the knowledge that they're funding all of the World Bank's sustainable development activities,” said Bennett. “But what they don't get is the link to a specific project or programme.”
Investors cannot say ‘my money went to this project’. They also cannot say that, ‘because I bought this bond, this project got funded’.
“But a few years ago, we started to hear more and more requests from some investors that a direct link to a project is something that they wanted – at least for a portion of their portfolio,” he said.
World Bank bond buyers are, for the most part, high-grade fixed-income investors happy to contribute to the Triple A rated bank’s sustainable development programme on an aggregated basis but not willing to take on the risks that come from financing individual projects.
Outcome bonds satisfy the two-fold requirement of a conservative bond-buying cohort: principal protection that earns a modest return and an identifiable sustainable impact from their investment.
Contingent outcome
With outcome bonds, all the proceeds raised contribute to the bank’s overall sustainable development pool. This feature ensures the principal is, effectively, World Bank risk.
“Because outcome bonds are principal-protected issuances by the World Bank, the principal has been awarded AAAp ratings from S&P,” said Bennett. “And that’s important because it means that outcome bonds can potentially be purchased by the target audience for this product: high-grade fixed-income investors.”
Funding for the project is generated by net present valuing a portion of the coupons. These are split into a fixed and variable component.
“Investors are exposed to World Bank risk for the principal and a fixed portion of the coupon payment, with the remainder of the coupon used to finance the project,” said Bennett. “In return, investors earn a variable coupon tied to the success of the project’s outcome.”
In its most recent bond, a nine-year US$225m Amazon reforestation bond, the bank pays an annual fixed coupon of 1.75%. That compares to an equivalent World Bank nine-year bond issued at the same time that would have paid around 3.9%, according to Bennett.
The net present value (NPV) of the remaining coupon stream (around US$36m with the reforestation bond) is achieved through swaps, and that is the amount that goes to fund the project.
Funding is not necessarily disbursed in one go. Certain milestones need to be achieved before funds are released to the project or projects. In the case of the Amazon bond, milestones are set around Mombak, the underlying project operator, being able to acquire degraded land for reforestation.
“We don't hand the whole US$36m up front, there's a set schedule of multiple payments over the first two years of the lifetime of the bond, conditional on Mombak actually contracting to purchase land or entering into partnerships with existing landowners,” said Bennett.
There is then another waiting period, expected to be about three years from when the land is acquired, until the forest is big enough to start producing carbon credits. From year five to year nine, the bond pays an additional variable coupon based on the success of the reforestation project and financed by the sale of the carbon credits produced – in this instance to Microsoft. The price paid by Microsoft flows back through to the World Bank, which passes them onto investors in the form of annual variable coupons that are paid in addition to the fixed coupon.
“There are two hedging transactions going on with this deal,” said Bennett. “One is the traditional cashflow swap where we receive the annual coupon of 1.75% against a floating-rate payment, and we receive the NPV of the remainder of that coupon to create the cashflows we need, both for the investment in the project and for the annual coupon repayment.
“In addition, there’s a forward flow agreement with the lead manager on the transaction [which was HSBC on the reforestation bond], a type of intermediation agreement by which we pass payments to Mombak and Mombak passes the proceeds from Microsoft back to us.”
Payment credits
For outcome bonds to work, projects need the potential to generate revenue; this revenue funds the variable coupon payments. And it is this requirement that forms one part of a dual test to determine the suitability of a project for the product.
Projects need to conform to the sustainable development agenda at the bank and satisfy the World Bank’s due diligence and, secondly, they must also produce revenues to pay off the upfront funding the bank is providing.
“We're looking at three different types of projects,” said Bennett. “Revenue could be generated with the sale of ‘credits’ on the open market or to a specific buyer, it could come from donor funding, or it could be linked to more direct revenues created by the project or entity.”
The Amazon reforestation bond, the fifth in the bank’s series of outcome bonds, represents an example of a project producing tradeable credits. It has already issued other bonds generating carbon and plastic credits: an emission-reduction bond linked to carbon credits produced as a result of a project in Vietnam to manufacture and distribute water purifiers; and a bond linked to plastic waste and carbon credits generated by two projects in Ghana and Indonesia aimed at reducing and recycling plastic waste.
Its Rhino bond – a wildlife conservation bond in support of South Africa’s efforts to conserve endangered species, used a contingent grant from a donor to pay off the coupon based on the success of the project.
And its first bond, which frontloaded finance to support Unicef’s pandemic response programmes for children around the world, is an example of a payback linked to an entity or project that produces revenues itself. Unicef used a portion of its large volume of annual donations to pay back the funding.
Significant scaling
As well as aligning to World Bank priorities, satisfying its due diligence requirements and offering the necessary financial return, any chosen project must also have the right characteristics to attract investors – and attracting more investors into this product is the next step in creating a meaningful sustainable difference.
“The whole point of what we're trying to do is to make a product that can be bought by high-grade, fixed-income investors, which is where a lot of the money in debt capital markets sits,” said Bennett. “We didn't want to create a product that was so bespoke that only very few investors can look at it.
“By creating this AAAp rated product with a guaranteed minimum coupon, we think we've found something that has a fairly broad level of appeal to our target audience.”
Scaling the product will be the real test of the structure’s level of success and that will require more bonds, larger bond sizes and the participation of other issuers. Issuing more and larger-sized deals should widen the investor base and increase liquidity – two things demanded by the major bond funds. Bigger deals require bigger projects or the packaging of multiple projects targeting a similar outcome within one transaction, such as with the Indonesia and Ghana plastic waste-reduction deal.
“And the other scaling we hope to see is from more issuers getting involved,” said Bennett. “We've got a growing pipeline of deals that we’re working but we’ve also heard that some of the regional multilaterals are showing interest. I think we're going to see more issuers.”
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