Response to The Economist’s view on Blended Finance
Cedric RIMAUD, CFA
Under the assertive title of “Blended finance is struggling to take off”, The Economist magazine, in its 15th August edition, points to an area that we, at Earth Wake, are all too familiar with. According to convergence, the Economist argues, blended finance is a small $20 billion a year -which is well below the need of spending required to support a more equal and climate-resilient society in low and middle-income economies. They also argue that this is caused by “financial wizardry”, “lack of transparency” or because the “internal workings [of multilateral development banks] incentivise grant-making over blending.”.
Over the past four years, Earth Wake’s internal research as well as participation in conferences, workshops and other thematic gatherings has shown us that there is definitely interest from both the private sector (e.g. banks and investment managers) and the public (UN agencies, multilateral development banks) on this topic. However, bridging the two sides remains a key challenge. Very often public experts call for “greater participation from the private sector”, as a lack of communication between the two sides remains problematic.
What are the true barriers to blended finance taking off?
1. Skewed perceptions of risk
First, the perception of risk by investors is skewed. Investors tend to believe that it is safer to allocate a large portion of their portfolio to negative-yielding public bonds rather than seeking higher yielding investment opportunities in markets where the strong rate of growth gives them a long-term return. Less than 4% of global bonds yield more than 5% globally and 20% of them are negative yielding at the present time.
Investors argue that the risk is too high, as they only expect to suffer minimal losses in a small portion of their portfolio. However, by limiting individual exposure, higher returns on the diversified portfolio will counter this risk. Portfolio theory has shown that, when 20 uncorrelated investments or more are pooled together, the risk is diversified away. Investors should therefore consider allocating a small portion of their portfolios to an investment that consists of 30 to 50 different projects from various corners of the EM world. Fidelity Investments, a large US asset manager with $2.5 trillion of assets under management, argues that “rotating from developed market to emerging market debt can reduce risk in a portfolio” and “EM hard currency debt has historically exhibited lower spreads and slightly lower volatility than high yield”.
2. A lack of liquidity
Secondly, investors are concerned with the lack of liquidity when it comes to blended finance investments. Large asset managers have specific guidelines to invest only in “benchmark” deals. A large bond issue, bought by a large number of investors, is more likely to have secondary liquidity than a small bond placed with a few investors. Investors expect that they will need to find someone to buy the investment from them at some point in the future, should they have a redemption that forces them to sell down their holdings. Their prudent risk management policies force them to wait for the large deals, rather than accumulate small transactions. Yet, anyone trading in the Emerging Markets corporate bond market knows that liquidity is relative. “Benchmark” deals are very often parked into “buy and hold” portfolios with very little secondary market activity. It can be challenging to find a buyer at the prevailing market price, and buying them in size after the issuance is difficult.
In stark contrast, the appetite for new green bond offerings is very real, with books several times oversubscribed in a typical offering. Investors have come to know that if they do not get their hands on green bonds at issuance, it is difficult to subsequently buy them in secondary markets. We would argue that there is some room for both types of investments. In a global portfolio, there are different layers of investments, with a portion being liquid. This ensures that the fund manager can quickly raise cash if its client wishes to redeem their investment. However, a large portion is not immediately available. Therefore, opting for short-dated instruments (such as 3- to 5-year corporate bonds) bought at different times will ensure that there is some liquidity coming into the portfolio on a regular basis.
3. Smaller investment projects
Investors voice concern over the size of blended finance projects. Indeed, the projects are usually much smaller than large “benchmark” deals. However, there are many opportunities to find attractive credit borrowers and combine them into a diversified portfolio that will yield attractive returns and there are solutions that enhance the credit of issuers. In one of our recent articles on “Small and Medium-sized Enterprises” Financing in Singapore”, we highlighted the importance of guarantee schemes to allow SMEs to better access financing. The efforts of the Asian Development Bank and others to allow bond issuers to benefit from their guarantee for debt raising purposes is a very good, long-term solution to support development. The recent opening of the Cambodian corporate bond markets, with several issues guaranteed by Credit Guarantee & Investment Facility, is an excellent demonstration of this, and more such efforts should be encouraged.
We at Earth Wake want to support these efforts and be part of the “financial wizardry” that is combatting the obstacles of blended finance deals. The field is endless for financing smaller projects in the Emerging Markets, and in Asia Pacific specifically, the region is awash with opportunities.
As we argued in our report titled “Finance for Climate Action in Asia and the Pacific: Regional Action Agenda to Access Debt Capital Markets” in December 2017, there are solutions to use the power of a regional financial center, like Singapore, to redirect capital towards green and social projects in the region. The recognition we received from the Luxembourg International Climate Finance Accelerator is a demonstration that we are not alone in our belief that this is possible.
Much remains to be done and working to show the potential of the blended finance model is a complex and often time-consuming process. However, the growth of the green, social and sustainability bond markets globally, now exceeding $1 trillion USD globally, is a demonstration that thematic instruments are attractive to global investors. It is true that this is only 1% of the global bond markets, but this has been achieved in roughly 5 years, with an incredibly strong rate of growth. The strength of this rise shows that the instrument is intrinsically no different from traditional bonds. With refined environmental and social objectives, and standards in place to govern these markets, the foundations are solid for strong growth in the future.