Under pressure from shareholders, multilateral development banks are exploring innovative solutions to boost their lending firepower to emerging markets for sustainable development. This includes the use of hybrid capital, which will allow MDBs to lend more without impacting their triple-A credit ratings due to these securities being treated as equity by credit rating agencies. However, being subordinated in the capital structure, MDBs will have to pay significantly more for hybrid bonds over what they pay for conventional funding.
Talk of MDBs issuing hybrid debt has grown in recent years. An independent review of MDBs’ capital adequacy frameworks by the G20 recommended MDBs explore hybrid capital. This was followed by the World Bank and African Development Bank announcing the intention to issue hybrid bonds, with the latter embarking on a roadshow in September to market the first public hybrid by an MDB in the capital markets.
After receiving a double A-minus rating by S&P for its proposed hybrid capital bond – the highest ever rating for such an instrument – the AfDB embarked on a series of investor meetings around the world for its debut offering. These were led by BNP Paribas and Goldman Sachs as joint structuring agents and global coordinators, with Bank of America and Barclays joining as joint bookrunners.
The debut offering is expected to be sized in a benchmark format (so anywhere between $250m and $1bn) with a sustainable label and either a five- or 10-year non-call option. Hybrid bonds come with perpetual maturities but can be redeemed by investors at the call date, at which point the coupon is reset.
Creating a new market
The deal has proven to be popular, with the AfDB meeting with over 130 investors in total. This is notable even for a debut trade in a new asset class. Given the perpetual maturity and subordinated nature of hybrid securities, the deal has not appealed to some of the traditional investor base of the public sector bond market such as central banks and official institutions. But it has appealed to other investors such as asset managers, pension funds, insurance companies and hedge funds. In many ways, AfDB is having to build an investor base from scratch.
The tricky aspect has been figuring out the price of the deal. How does one begin a price discovery process for the first ever hybrid bond by a triple-A MDB? What is the price differential between the AfDB’s senior and subordinated curve? These are tough questions the issuer is having to work out with investors.
It is understood that investors have been asking for a spread of 150-200 basis points over the AfDB’s usual cost of funding at five years for a perpetual non-call five-year hybrid. While that seems an astonishing number and range, it is line with the spreads that banks and corporates pay for hybrid securities. Also factored into this is the so-called ‘first mover premium’ the AfDB will have to pay for bringing the first public sector hybrid. It is creating a new market.
If the AfDB and other MDBs end up paying that much for hybrid issuance, is it worth it? Some would say it isn’t. Cost-efficient funding is at the heart of public sector issuers. Yes, the hybrid debt model unlocks more lending, but at what cost? It is a fine balance for MDBs between offering value for investors with subordinated debt while remaining cost efficient in their funding. This is also not just a one-off exercise, with MDBs planning on integrating hybrid debt as a permanent feature in their capital structure and funding programmes going forward. MDBs are right to be cautious about how much they pay for these securities.
One alternative is for MDBs to bypass the capital markets and offer the hybrid securities directly to their shareholders and partners as a private placement offering, which the World Bank has been doing. Last September, Germany became the first country to provide hybrid capital with a €305m private placement for the World Bank. More shareholders are expected to follow in supporting the World Bank’s hybrid programme. Like the AfDB, the World Bank is also looking at developing a public hybrid programme for the capital markets.
Keeping the price down
Issuing directly to shareholders would keep funding costs contained as the price would not be reliant on a large group of private sector investors. It would also be attractive to shareholders, who would receive a coupon for their investment. But shareholders wouldn’t get the voting rights they would get with a regular capital increase. Instead of treating this as an investment, some shareholders intend to treat hybrid securities as official development assistance, meaning they would forgo coupon payments.
However, MDBs can only rely on their shareholders for so much, especially if hybrid debt will be a regular and permanent feature. Only a few years ago, the AfDB’s shareholders more than doubled the bank’s capital base with the largest capital increase in its history. Meanwhile, the European Bank for Reconstruction and Development – which is also tentatively looking at how it can issue hybrid debt – is looking to agree its third paid-in capital increase since its inception in 1991.
There are other innovative ways for MDBs to unlock more lending. These include shifting part of their portfolios and transferring the risk to the private sector through synthetic securitisations. This is something that the AfDB has also been at the forefront of and it was a recommendation included in the G20 report last year. These transactions are not very straightforward, however, and require a lot of work.
Perhaps the best solution for unlocking more lending to the developing world is mobilising more capital from the private sector through commercial and investment banks to support the mission of MDBs.
Before the 2008 financial crisis, MDBs were able to lean on banks for around three times more financing than they would provide for projects and direct lending to the real economy. This level of investment from banks has since diminished as a result of the substantially higher reserve capital requirements for banks under Basel III. The rise in risk-weighted assets for project finance lending was harsh given that this part of the market was not impacted by the crisis and did not contribute to it.
A revision to this regulation to allow banks to return to similar investment levels and support MDBs would make sense and offer a clear path for substantially more lending to emerging markets.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.