Converting speculative-grade exposure into investment-grade exposure

G20 and MDBs

In 2015, the international community adopted the Sustainable Development Goals (SDGs). The MDBs, which are supposed to provide countercyclical financial resources, play crucial roles in the endeavor to achieve the SDGs.² As vital pieces in the international financial architecture, they were major contributors to the Millennium Development Goals.

Each year, MDBs borrow through public issues and private placements.³ They have relatively large annual borrowing programs and high credit ratings. Because high credit ratings are particularly relevant to MDBs’ sovereign guaranteed operations—lending to member countries that are both clients and shareholders, MDBs have striven to maintain their high credit ratings. With credit rating targets imposing binding constraints on financing operations, in 2013, the G20 asked finance ministers and central bank governors to “explore the ways in which private financing and capital markets can be better mobilized” and called on MDBs to “develop new approaches in order to optimize the use of existing resources.”⁴ In 2015, the G20 endorsed the Antalya Action Plan, which contained five objectives: improve capital efficiency, deploy exposure exchanges, utilize the concessional windows, engage in risk sharing and transfer, and discuss net income measures with shareholders.⁵ In 2023, the G20 committed to increase substantially the financing capacities of MDBs, endorsed a review of MDB capital adequacy frameworks (CAFs), and called on MDBs to leverage private capital through innovative financing models.⁶ In 2024, G20 finance ministers and central bank governors issued a series of recommendations, including the following: strengthen countries through capacity building, boost private capital and domestic resource mobilization, continue the implementation of CAF reviews, and develop and promote innovative financial instruments.⁷

During the last decade, MDBs have executed creative transactions and made framework changes.⁸ Still, numerous opportunities with high development impact—especially in the areas of capital market development, local currency lending, and bankable project pipelines—exist.⁹

A liabilities approach based on guarantees

The specific guarantee-based liabilities approach to MDB balance sheet optimization presented in A Liabilities Approach to MDB Balance Sheet Optimization was intended to convince policymakers that the entire balance sheet warrants attention. The simple approach highlighted that, just as assets can be managed through insurance, liabilities can be managed through guarantees.¹⁰

An MDB that engages in sovereign guaranteed operations and non-sovereign guaranteed operations from the same balance sheet, such as AfDB, was considered.¹¹ Wishing to increase its volume of borrowing without an adverse effect on its credit ratings, since sovereign guaranteed lending is on a pass-through basis and non-sovereign guaranteed financing is on market terms, the MDB separates capital market operations associated with sovereign guaranteed lending from capital market operations associated with non-sovereign guaranteed financing¹² by creating Capital at Risk Notes (CaRNs) within its Global Debt Issuance Facility (GDIF)¹³. CaRNs are speculative instruments designed for sophisticated investors: they may contain numerous contingent claims; they do not have the credit ratings of GDIF; they need not be rated; and they are not required to be registered under the United States (US) Securities Act of 1933.¹⁴

With CaRNs, the MDB funds non-sovereign guaranteed operations from capital markets on the basis of non-sovereign guaranteed portfolios and third-party partial guarantees.¹⁵ The basic mechanics of a funding operation are as follows:

1. The MDB issues CaRNs backed by a) the flows from a non-sovereign guaranteed portfolio and b) the protection of a third-party partial guarantee;
2. The full amount of proceeds is invested in the non-sovereign guaranteed portfolio; and
3. The CaRNs are repaid from the income generated by the non-sovereign guaranteed portfolio, with any shortfalls covered, in part or in full, by the third-party partial guarantee.

The partial guarantee is obtained through a competitive process, and the non-sovereign guaranteed portfolio is originated in line with the MDB’s regular standards.

Converting SG Exposure into IG Exposure

In the liabilities approach described above, the MDB can use partial guarantees to convert SG non-sovereign guaranteed portfolios into IG exposures. The credit rating of the guarantor and the coverage terms of the guarantee are determinative. Moreover, in principle, any EM asset holder with a reliable origination function can employ the approach. However, in practice, MDBs tend to have better access to guarantees than private-sector institutions. Therefore, a novel methodology, with the following basic mechanics, is proposed:

1. A special purpose vehicle (SPV) purchases the flows from an SG portfolio;
2. The SPV purchases triple-A rated notes from a DFI/MDB that bring its credit rating to the desired IG level; and
3. The SPV issues IG notes that fund the purchases in a) and b).

In a), there are two reasons for the focus on flows. First, whenever the SG portfolio is originated by a DFI/MDB, the DFI/MDB should remain lender of record. DFIs and MDBs have lower rates of default than commercial lenders, and they are ideally positioned to manage borrower issues. Second, in order to align interests, the originator should retain some exposure to the SG portfolio. With flows, it is trivial to split the SG exposure between the originator and the SPV.

In b), the SPV could purchase US Treasuries to achieve a similar outcome. However, doing so would maximize neither development impact nor portfolio return. The borrowing programs of DFIs and MDBs should resolve challenges, and the US offers lower returns than triple-A rated DFIs and MDBs.¹⁶

As usual, the SPV may issue different tranches of IG notes.

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