The investment needs for climate mitigation and adaptation in low- and middle-income countries (LMICs) other than China is estimated at $783 billion per year between now and 2030. While the World Bank reports that bonds are the most important debt instrument for these countries - comprising the majority of the $161 billion net debt inflows from private creditors to LMICs on average from 2018 to 2022 - there is a clear need for innovative climate financing structures to close the persistent investment gap.
While this need is urgent, blended finance to create climate bonds has remained relatively nascent. In Convergence’s Historical Deals Database (HDD) of blended finance transactions, bonds account for only 8% of the 1,233 deals. There is, however, growing interest to use blended finance for climate bonds; Convergence data shows that in climate-related transactions, blended finance bonds were deployed more in 2023 than in previous years. As a proportion of annual climate financing volume, “blended climate bonds” have grown from 2% of total climate blended finance in 2017 to 9% in 2023.
In our post on 2024 blended finance trends, Convergence noted that there are increasing opportunities to use blended finance to promote green, social, sustainable, sustainability-linked and other (GSS+) bonds. As one of the lesser-used vehicles, it is worth a deeper look at why blended bonds are an important instrument and how blended finance can be used to encourage its uptake in climate initiatives.
Understanding bonds as important debt instruments
One of the biggest benefits of bonds as a debt instrument is that they are typically publicly listed and traded – thereby increasing liquidity, unlike other debt instruments (e.g. loans and notes), which are more frequently closed through private transactions. Continuing to originate and structure debt as loans or notes in private markets means transactions are mostly unavailable to a large number of investors. Through publicly listed bonds, a larger investor pool can be reached, thereby increasing investor demand and investment volumes and decreasing interest rates. Public trading of bonds reduces the uncertainty of market price, since high trading volumes help ensure the true value of the underlying asset.
Most investors require bond issuers to be rated by credit rating agencies such as Moody’s, S&P, or Fitch. The main driver of a bond rating in any country is the sovereign risk rating, known as the sovereign ceiling. Bonds issued in countries with weak ratings (e.g., B or lower) lie beyond the fiduciary and regulatory investment mandates of most global debt investors (generally, investment grade BBB). A huge challenge of using bonds in emerging markets is the limited number of issuers that meet investors’ fiduciary and regulatory investment risk mandates (e.g., 76% of developing countries are rated B or lower).
Blended finance can be used to address the risk challenge by structuring bonds to fit within investors’ risk mandates and provide market risk-adjusted returns, thereby overcoming the sovereign ceiling and improving the creditworthiness of the issuer.
Blended finance funds to increase the creditworthiness of bonds
There are several blended finance approaches to create a bond that meets investors’ investment risk mandates. The simplest is for a more creditworthy guarantor to provide a guarantee for the bond; for example the World Bank Group (rated AAA) or a private entity like GuarantCo or Green Guarantee Company issuing an investment grade guarantee (A and BBB respectively).
An alternative effective and efficient approach is through creating a tiered blended finance fund that invests in climate debt (e.g., loans, notes and bonds) in developing countries. For example, a fund can be established with three tranches of capital: senior, mezzanine, and junior. The junior tranche is essential for success; it is the most catalytic tranche since it faces the highest risk – typically beyond the ability or willingness of multilateral development banks (MDBs) and development finance institutions (DFIs) to invest. It is typically financed by climate impact organizations like country members of the Organization for Economic Cooperation and Development (OECD) Development Assistance Committee (DAC), the Green Climate Fund (GCF), or philanthropic foundations. The mezzanine tranche should be structured to be investible by MDBs, DFIs, and high-yield investors, for example rated CCC or B with commensurate return.
The diversification of assets in the fund and the 10% to 20% subordination allows the senior tranche to be in the form of an investment grade (e.g., BBB) bond. In general, BBB rated bonds that are listed and traded, liquid, and large enough, allow almost all debt investors to invest.
Using blended funds to support the issuance of climate bonds is the most effective and efficient approach for several reasons:
- High scalability: A fund issuing bonds can be sized from $200 million to $20+ billion. Investors want size, but most climate projects do not require the large amount of debt to justify a bond – aggregating debt to many projects creates the necessary size for bonds.
- Diversification: A fund delivers country and borrower diversification, and usually achieves a two-notch upgrade delivering one-quarter of the required credit enhancement (subordination delivering the other three-quarters).
- Effective use of capital: While a full guarantee protects the total amount of the bond to overcome the sovereign ceiling, this may not be the best use of scarce concessional public funding. Most public sector issuers of guarantees are AAA or AA rated MDBs (e.g., Multilateral Investment Guarantee Agency) or developed countries (e.g., Germany). Debt investors neither need nor want such strong guarantees. Rather, they need to be credit enhanced beyond underlying CCC and B risk of the borrower. In general, a low investment grade rating (e.g., BBB) is sufficient and preferred to mobilize private capital. Tiered funds can issue investment grade bonds as the senior capital, and non-investment grade bonds as the mezzanine capital, which frees up large amounts of public capital to invest directly for impact and leverage additional funds.
- Sufficient at de-risking: Other means of blending, such as partial guarantees, are likely less effective since credit rating agencies’ methodology for partial guarantees is to provide only a one- to two-notch upgrade from the underlying risk. Therefore, if the underlying risk is CCC, a partial guarantee would likely upgrade the bond to B-, which is still beyond the fiduciary and regulatory mandate of most debt investors. With a multi-tiered fund, the combination of diversification and catalytic junior and mezzanine tranches allow the senior capital to be an investment grade bond.
GSS+ Bond Certification
While blended finance structures increase the creditworthiness of bonds, bond certification can help further mobilize private capital into the asset class. Through its bond certification program, called the Climate Bonds Standard and Certification Scheme, CBI encourages investment in GSS+ bonds by supporting investor confidence in the climate change credentials of green bonds and other instruments. The program is designed to assist investors and governments in prioritizing investments that address climate change, using a science-based approach consistent with the goals of the Paris Climate Agreement to limit warming to 1.5 degrees Celsius.
CBI believes that investing in reputable GSS+ bonds—those with Climate Bonds Certification or a solid Second Party Opinion—gives investors confidence in the bond's environmental credentials. This approach broadens the range of eligible green investments since investors are not limited to exclusively green companies, and it also lessens the need for extensive due diligence because GSS+ issuers are expected to provide post-issuance reporting.
Overall, blended bonds at risk ratings aligned to fiduciary and regulatory mandates offer an important and growing opportunity for investors to diversify their portfolios and engage in climate-friendly investments. While organizations such as CBI are advocating for the creation of more transparent and responsible GSS+ bonds, concessional finance can be used to address perceived and real risks associated with these bonds.
Convergence and CBI will hold an information session on climate blended bonds on November 25, 2024 at 10am ET. Please register here. Please direct any enquiries to [email protected].
