Reflecting on financial opportunities and governance strategies: the attractiveness of green, blue and other impact-oriented bonds

Generally speaking, assessing the attractiveness of impact-oriented bonds (IOBs), including green, blue and social impact bonds, revolves around two aspects: understanding the financial opportunity of the investment and recognizing its expected environmental and social (E&S) benefits and outcomes.

Financial opportunity

In principle, financial investors (FIs) may be persuaded to invest in an IOB only if the financial outcomes (expected returns) of such investment are equal or better than other impact-oriented investments available in the market with a similar risk profile.

In this context, it should be noted that an IOB’s yield is not necessarily affected by its sustainability tag (at least not substantially) but rather by the credit rating of the issuer, similar to a traditional bond  (as researched by Vaneck and Kapraun & Scheins). Therefore, if the IOB’s issuer wishes to attract FIs, such investment should generate a level of financial return proportional to the issuer’s credit rating.

The financial opportunity should then be mainly assessed in terms of the coupon interest rate and maturity, also considering how these factors compare to similar financial products available in the market. Of course, like any other financial product, additional indicators should be evaluated, such as those related to investment returns (ROI, IRR/YTM, NPV and other cash-flow measures) and risks (e.g. interest rate, inflation, liquidity, credit risk and, more generally, the issuer’s financial performance and resilience).

Arguably, the liquidity risk (intended as the possibility to convert the financial product in cash in a short time and at a fair price) still represents the main inherent drawback for investing in new IOBs: trading potential for innovative products are typically low, therefore investing in these funds would be justifiable only if the FI intends to maintain its participation until maturity; although, liquidity may improve as impact-oriented bonds and ESG investments are becoming increasingly more popular.

In terms of credit risk, IOBs are sometimes sponsored and operated under a guarantor (e.g. a development bank) scheme: this means that the actual coupon payable by the IOB issuer can be reduced and partially covered by an external guarantor.

Some important benefits must be recognized. Firstly, the IOBs offer great potential for portfolio diversification, as their performance may not be necessarily correlated with the typical macroeconomics trends and environment. Secondly, investing in innovative and sustainable products translates into significant reputational benefits for the FIs, especially in light of the increasing awareness regarding ESG investments. 

E&S benefits and outcomes

Issuers of IOBs maintain an obligation to fund initiatives with tangible E&S benefits. Ignoring this mandate in some cases would turn into a policy breach and ultimately undermine the issuer’s credibility. Therefore, it is paramount that a level of oversight is applied across the IOB’s proceeds to ensure that funds are accomplishing the E&S objectives.

To this end, the issuers must ensure responsible and effective management of the IOB’s proceeds, establishing robust governance and sound overarching E&S targets. Reasonable eligibility criteria should be set to ensure that the IOB’s proceeds are responsibly directed to sustainable and impact-oriented projects. Regular reports about achieved E&S benefits and informative materials of accomplished projects should be made available to FIs and key stakeholders.

How to drive environmental and social governance? Six considerations for IOB issuers

From the issuer’s perspective, an IOB is successful when IOB’s funded initiatives are in a position to (i) maintain a satisfactory and sustainable cash flow and (ii) meet E&S targets. Factors that cause funded projects and initiatives to fail usually follow common patterns, including poor business models, uncertain/unspecific program targets, and lack of local capacity. In the context of E&S projects, rampant greenwashing can easily exacerbate these factors.

In my experience, strategies to strengthen issuers’ governance and increase the chance of success must address the following six areas.

1. Program orientation and targets: IOB-funded projects should be provided with strategic instruction and orientation from the issuer or its delegated manager. SMART (specific, measurable, attainable, realistic, and time-bound) and program-wide financial and E&S goals should be established, together with bespoke key performance indicators and an action plan. In addition, for every funded initiative, the issuer should take the lead in defining project-specific targets that can actively contribute to the IOB financial and E&S goals. The local environmental and socio-economic baseline should be regularly and cyclically re-assessed (e.g. yearly) to enable the continuous identification of emerging critical needs, opportunities, and strategic available resources.
2. Selection of project/programs to be funded: complementarity, integration and diversification should be promoted in the initiatives selected to be funded with IOB proceeds, favoring methodologies that assess the potential contribution that each project can bring to the achievement of the overall IOB goals. In this sense, initiatives that possess predominant environmental value but poor commercial potential could be complemented, for example, with projects with more convincing financial returns but slightly weaker environmental benefits, as far as the overall IOB’s E&S targets are met. It is always important to select projects that fully meet the issuer’s vision and do not jeopardize its impact-oriented mandate. 
3. Capacity building: very often, the successful implementation of funded initiatives requires participation and involvement of local communities. Local capabilities should be developed and strengthened to enhance managerial skills and increase the chances of success for funded initiatives. Local entrepreneurs may be trained in project management, technical and financial disciplines, and in all key aspects that drive the IOB’s program, such as climate resilience, E&S impacts and management, and impact-oriented opportunities, to name a few.
4. Monitoring and reporting effectiveness: issuers should agree on project-specific financial and E&S milestones and targets (aligned with IOB-wide targets) for each funded initiative and assess progress through periodical reports on work plans. Additionally, regular audits should be undertaken by the issuer for verification purposes.
5. E&S management: E&S management systems designed in accordance with international standards (such as the IFC or the IDB’s new Environmental and Social Policy Framekwork) are robust tools to strengthen the issuers’ governance and institutional capacities. The implementation of an E&S management system facilitates portfolio oversight and greatly improves FIs’ confidence.
6. Program standardization: formalizing the concept of IOB and setting recognizable standards for these innovative financial products  (such as the Blue Action Fund standards) will lend credibility and transparency to the IOB. This, in turn, could enhance the future liquidity of the IOB.

IOBs as a new paradigm of sustainable and resilient investments

Compared to traditional bonds, IOBs are certainly more sophisticated products: we finally have a form of investment that not only recognizes environmental and social externalities but also paves the road for global positive changes and a new paradigm of sustainable and resilient investments.