A true ‘pandemic bond’ looks more like an insurance product than a fixed-income product…
The first pandemic bond was issued by the World Bank in 2017 to facilitate funding to developing countries facing the risk of a pandemic. According to the Bank’s own statement, the issue “[marked] the first time that World Bank bonds are being used to finance efforts against infectious diseases, and the first time that pandemic risk in low-income countries [was] transferred to the financial markets”.
A pandemic bond is structured as a type of catastrophe bond—that is, a fixed-income instrument that offers investors a high yield unless certain trigger conditions come to pass, in which case investors lose their investment and the funds are instead used to help address the crisis. Catastrophe bonds are issued by insurers or reinsurers to help transfer risk; pandemic bonds would almost certainly be issued by multilateral institutions like the World Bank, or by national governments.
The World Bank’s pandemic bond issuance totalled $320m, and in April of this year the Covid-19 pandemic triggered the instrument’s first payout, of around $200m. The 74 member countries of the International Development Association, the World Bank’s concessional finance arm, were eligible for payouts; 64 low-income countries received funds. Nevertheless, the bond was criticised for being ineffectual. Investors were receiving interest payments as late as February 2020, and many have argued that the time it took for the stringent payout criteria to be met (one of the trigger criteria was in fact that at least 12 weeks must have passed from the start of the outbreak) meant that by the time the funds were disbursed, they were too late to support effective early-stage prevention and mitigation measures. Given the scale of the crisis, the amount of funding on offer might also be seen as insufficient to be truly impactful. In July, the World Bank scrapped its plan for a second pandemic bond.
If catastrophe bonds are an imperfect financial response to a pandemic, what should we make of more traditional debt issuance linked specifically to the current crisis? Although pandemic bonds, and catastrophe bonds more broadly, are labelled ‘bonds’, they are perhaps more closely related to insurance products than to conventional fixed-income securities (because the trigger for payout, prompting investor losses, depends on a specified event either happening, or not).
…while other bonds that are being described as ‘pandemic bonds’ are actually ‘social bonds’
In contrast, a number of issuers have this year sold bonds where the funds raised, or a portion of the funds raised, are earmarked specifically to address the Covid-19 crisis. Although these bonds have been issued to direct capital towards pandemic-mitigation efforts (for example, improving healthcare infrastructure or advancing vaccine development), they are in fact a type of social bond (also known as social-impact bond), rather than a true pandemic bond as described above.
Social bonds are fixed-income instruments where the funds raised are earmarked for something designed to improve social outcomes. In this way, they are very similar to better-known green bonds, which are bonds in which the funds raised are earmarked for something designed to make a positive environmental contribution. Both green and social bonds could be considered part of the wider universe of sustainability bonds—though it is important to note that definitions are fluid and non-standardised. Indeed, this lack of commonly-agreed definitions and classification systems is a major barrier to using financial markets to address social issues, because without standardised definitions, it is impossible to make informed and robust comparisons of different products’ risk/return profiles.
This challenge has been well documented for green finance; for example, our research with Imperial College Business School has addressed the ways that lack of standard definitions and benchmarks inhibit scale in green infrastructure investment. (This is notwithstanding the work that has already been undertaken in this area—some systemic, and some relating to specific sub-sectors within green finance.) But in areas that are even more difficult to quantify clearly, such as societal well-being, the challenge will be even greater.
Investors often turn to ratings agencies to assess the sustainability credentials of potential portfolio companies—but the methodologies of ratings agencies themselves are non-standardised and therefore highly subjective. This is not a criticism of ratings agencies: credit ratings can be comparable because they seek to answer a standard question consistently, whereas environmental and social ratings cannot be comparable as long as the questions being answered differ. The ‘Big 3’ ratings agencies, as well as a host of smaller, specialised ratings agencies, have taken an increasing focus on ESG (environmental, social and governance) factors in recent years. The distinction between, on the one hand, incorporating ESG factors into credit ratings and, on the other hand, establishing separate ratings to assess ESG credentials, is important. Below is a summary of the approaches taken by the main credit-rating agencies as well several specialised firms.
- Fitch Ratings
In January 2019, Fitch Ratings launched a new scoring system: Environmental, Social, and Governance (ESG) Relevance Scores. The new scoring system takes ESG factors into account when Fitch makes its credit rating decisions. The ESG Relevance Scores are on sector-based and entity-specific bases. Fitch is the first credit rating agency that introduced how ESG factors affect credit ratings. When analyse the ESG impact, individual E, S and G are scored ranging from 5 (most relevant to credit ratings) to 1 (least relevant).
- Moody’s Investors Service
Moody’s published its General Principles for Assessing Environmental, Social and Governance (ESG) Risks in January 2019. The company takes the impact of ESG factors into consideration in its rating analysis for all issuers, including corporates and sovereigns. For corporate credit ratings, Moody’s assesses the ESG impact on corporates’ product demand, reputation, cost of production and financial strength; the impact is incorporated into assessments about profitability, leverage, cash flow, business profile, financial policy and scale (revenue/assets). For sovereign credit ratings, Moody’s considers the ESG impact on countries’ economic competitiveness, government effectiveness, rule of laws, political risk, control of corruption and revenue/spending needs; Moody’s methodology scorecard then assesses the impact with regard to the countries’ economic strength, institutional strength, fiscal strength and susceptibility to event risk.
S&P published its Environmental, Social, and Governance (ESG) Evaluation analytical approach in June 2020. S&P Global Ratings' ESG Evaluation analyses the ESG impact on an entity’s stakeholders. An ESG score indicates the ability of an entity that mitigates ESG-related risks and capitalises on ESG-related opportunities. The ESG Evaluation is comprised of ESG Profile and Preparedness. Firstly, S&P establishes an ESG Profile to assess ESG-related risks and opportunities for a given entity. Secondly, S&P assesses an entity’s ability to predict and prepare long-term ESG-related plausible disruptions, namely long-term Preparedness. The ESG Evaluation is not a part of S&P’s conventional credit ratings, but it provides information that can inform S&P’s credit analysis.
Beyond the ‘Big 3’, a wide range of institutions specialising in sustainability ratings and analytics has emerged. Examples of some organisations doing prominent work in this area are:
- Morgan Stanley Capital International
Morgan Stanley Capital International (MSCI) is a global index and analysis tool provider. The company applies artificial intelligence and alternative data to measure companies’ ESG ratings, aiming to test companies’ resilience to ESG-related risks. In September 2019, MSCI published its ESG Ratings Methodology. The MSCI’s ESG ratings method is to assess 37 ESG Key Issues through examining a company’s core business and the industry issues. These are contained in three pillars and ten themes:
- Climate Change
- Natural Resources
- Pollution & Waste
- Environmental Opportunities
- Human Capital
- Product Liability
- Stakeholder Opposition
- Social Opportunities
- Corporate Governance
- Corporate Behavior
After MSCI gives scores to each company, the companies are rated between the best (AAA) and the worst (CCC). The ratings are relative rather than absolute, with a company compared with industry peers.
The Institutional Shareholder Services group of companies (ISS) provides solutions to investors and businesses to support their long-term and sustainable growth. ISS’s ESG ratings provide research and data on companies, countries and green bonds to help investors making their investment decisions. The aim of the ratings is to support investors to minimise the ESG risks they face. ISS’ ESG ratings provides solutions in six areas:
- ESG Corporate ratings: analysing up to 100 rating criteria to assess a company’s ESG issues;
- ESG Country ratings: sustainability issues for all countries in the EU, OECD, BRICS and other regions are assessed;
- Governance QualityScore: a company’s governance risk is identified;
- E&S Disclosure QualityScore: a company’s environmental and social risk are measured;
- Carbon Risk ratings: a company’s climate-related issues are assessed;
- Custom ratings: allowing investors to establish their own view on ESG and manage their own ESG risk.
Social bond issuance has grown but is still dominated by sovereigns and supranationals
Despite the challenges, social bond issuance has grown significantly in 2020, driven in part by issuance of Covid-19-related bonds. For example, according to one estimate, as of June 2020, the total value of bonds issued to raise funds to manage the pandemic was $87.9bn. Most of this issuance has been from sovereigns or from multilateral and supranational institutions. For example, the African Development Bank (AfDB) issued a $3bn ‘Fight Covid-19’ bond in March, and the European Commission sold its first bond under the EU’s SURE programme--€17bn bond offering—on 20 October in an issuance that was notable for the unprecedented scale of the mutualised debt offering. Both of these issues were over-subscribed, but it is worth noting that demand has been strongest from public-sector institutions: 53% of the AfDB’s bond issue was allocated to central banks and official institutions, and central banks were also heavy buyers of the European Commission bonds.
This highlights two points about fixed-income instruments as agents of pandemic recovery. First, that that the private sector is under-utilised as a source of pandemic-related financing. Private-sector banks are of course involved in public-sector and supranational issues as underwriters and arrangers, but examples of private financial institutions issuing social bonds are rare. BBVA became the first private-sector bank in Europe to issue a Covid-19-related bond in May, launching €1bn of debt, part of which is earmarked for Covid-19 mitigation measures. This dynamic is, in many ways, unsurprising given that the social goals intended to be furthered by social bond issuance are core parts of the remit of governments and supranationals like development banks, but not necessarily part of the core functions of private-sector institutions.
Second, social bonds will face many of the same questions that have dogged better-known green bonds. Just as it has been unclear whether investors were motivated to buy green bonds to help fund environmental projects, or, instead, simply because they sought high-quality debt (or for some other non-environmental reason), investor demand for Covid-19-related bonds this year may be motivated largely by non-social considerations (for example, central banks’ desire to increase holdings of euro-denominated assets).
It is clear that the structure of pandemic and social bonds will need further refinement if they are to make a stronger contribution to mitigating the effects of Covid-19, as well as future pandemics. But the increased attention they have garnered this year will surely benefit not only the populations whose health and economic outcomes may be strengthened by the debt funding on offer, but the further development of these financial instruments themselves.
 For details, see TheCityUK and Imperial College Business School ‘Financing low-carbon infrastructure’, November 2019, available at: https://www.thecityuk.com/assets/2019/Report-PDFs/1e93c07cca/Financing-low-carbon-infrastructure.pdf