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    The Impact of Multilaterial Development Banks

    by Davide Guberti, FRM Passive & ETF Investment Analytics
    UBS AM

    What are Multilateral Development Banks (MDBs)

    MDBs are supranational financial institutions dedicated to providing financial support and know-how for economic and social development projects. They were founded by sovereign states which contribute capital and provide guarantees allowing MDBs to raise funds in international capital markets at attractive rates. Given that MDBs are non-profit organizations, they are then able to provide loans to less developed countries at attractive conditions.

    MDBs as a sustainable investment

    MDBs are backed by multiple sovereign member nations (including all G7 countries) which, in addition to their unique capital structure, allows them to receive a very high credit rating (usually AAA) from various credit rating institutions. Thanks to their high credit quality, MDBs can borrow at extremely low interest rate and use the proceeds to make loans for projects in developing county. Since MDBs lend at substantially discounted interest or provide grants to fund projects, they allow borrowers from developing countries to access credit at much more favorable conditions than those faced if they would borrow directly from private lenders.

    Because MDBs lend mainly to lower-middle and middle-income developing countries, they often opened up bond markets in emerging market currencies for international investors, contributing to the economic development of these regions. Other sources of financial and technical assistance have emerged in recent years in the form of foundations, Non-Governmental-Organizations (NGOs) and other multilateral organizations, yet MDBs remain a vital piece of the international assistance mechanism given their scale and reach.

    Most MDBs are active across all 17 of the UN Sustainable Goals (SDGs), and most projects and programs support multiple SDGs simultaneously. Looking at the “World Bank Group Annual Report 2021” we can see some recent examples of the types of impact projects that were financed by the World Bank Group: 

    • Respond to the COVID-19 Health Crisis & Partnering on Vaccines 
    • Investments in Climate Change 
    • Reduction of Countries’ Unsustainable Debt Burdens
    • Protecting Food Security by helping governments build robust and sustainable food systems
    • Addressing the Global Learning Crisis (the World Bank is the largest source of external financing for education in developing countries)
    • Boosting Social Protection Coverage
    • Closing the Gender Gap
    • Supporting over 30 Fragile and Conflict-affected Countries to address the COVID-19 Pandemic’s Impacts

    Even though each MDB bond proceeds cannot be directly allocated to a specific projects, the issuer institution is very transparent and discloses publicly every project’s progress, outcome and ultimate impact.

    Breaking down the index

    Traditional bond indices typically contain only a small amount of highly-rated sustainable debt. In order to increase their allocation to sustainable debt, clients should invest in dedicated solutions that explicitly focus on these types of securities. One way to invest in this segment is through passive solutions, such as the one created by the collaboration between Solactive and UBS Asset Management: The Solactive Global Multilateral Development Bank Bond USD 25% Issuer Capped Index. The index is designed to capture a representation of bonds issued by the largest MDBs that have all G7 countries as members. In Figure 1 we highlight some key features of the index construction, that ensure robust portfolio construction. First, only high credit papers are eligible. Second, it includes only USD denominated fixed-rate securities with a time to maturity no less than 12 months. Third, to ensure liquidity, only large bond issues are eligible (min USD 500 m). Finally, the index is market cap weighted with an issuer cap of 25% to enhance diversification.

    The index constituents include bonds from five different organizations as of August 2022:

    • World Bank Group comprising of the International Bank for Reconstruction and Development (IBRD), the International Finance Corporation (IFC) and the International Development Association (IDA)
    • Inter-American Development Bank
    • Asian Development Bank
    • European Bank for Reconstruction & Development
    • African Development Bank

    Each of the selected multilateral banks have a track record of robust performance, solid reputation, and play an important role in their respective regions. The weights of bonds issued by the World Bank, Asian Development Bank and Inter-American Bank are all at the maximum level of 25%. Overall, the index holds 97 different bonds with their individual weights ranging from 0.16% to 3.94% (August 2022).

    Index facts and figures

    In Figure 2 we show the historical Yield and Option-adjusted Spread (OAS) characteristics of the MDB Index since inception (2011). Looking at the Yield-to-Maturity (YTM) evolution over time, we can see that the MDB Index is strongly connected to the monetary policy actions followed by global central banks, particularly by the US Federal Reserve. This helps us to understand the recent sharp move upward of YTM for MDBs, which is linked to the monetary policy tightening implemented by several central banks to achieve their price stability objectives.

    Figure 2 also shows that, thanks their very low default risks and reasonably high market liquidity, MDB bonds only have a modest spread above “risk-free” sovereign bonds. Interestingly, even though YTM increased substantially in the last year, the levels of Option-adjusted Spread (OAS) remained low. As of end-August 2022, the OAS offered on top of US Duration Matched Treasuries stands at 12bps, which is below the historical average of 16bps.

    At times of high market stress, MDB bond spreads widen temporarily, mainly because of worsening liquidity conditions. In the chart we can see two main episodes: the Euro Debt crisis in early 2012 (where OAS peaked at 40bps), and the Covid crisis (OAS peaked at 54bps). On the other hand, it is interesting to see how these phases tend to be usually brief, with spreads reverting quickly and price losses being temporary and fully recouped as market conditions normalized.

    The additional yield of MDBs can be seen as a compensation for the slightly less liquidity that MDBs offer relative to US Treasuries. Over long-periods, the yield premium has helped to achieve greater returns while keeping a risk-return profile very similar to a portfolio of duration-matched US Treasuries. As shown in Figure 3, the excess returns since inception stands at approximately 220bps.

    The role of MDBs in an investment portfolio

    As shown in the previous section, MDB Index risk return characteristics are very much in line with those of US treasuries. This, paired with the high credit quality (AAA-rated), confirms that MDB bonds belong to the safest component of asset allocation (alongside other government-related bonds). 

    Since the role of the safest part of the portfolio is to diversify and offer protection during periods of high (equity) market stress, we expect MDB price dynamics to be unrelated to movements in the equity market. Figure 4 confirms that, if we take the MSCI ACWI Index as a proxy for the broad equity market, we can see how both our MDB Index and a US Duration-Matched Treasury Index (proxy for US treasuries), showed negative correlation in daily returns from the end of 2011 until today. 

    Thanks to their generally low or negative correlation to equities, their prices tend to remain stable, or even go up, when equity prices fall. As a such, the main role of MDB in a portfolio is to diversify and offer protection during periods of high (equity) market stress.

    In order to understand how this negative correlation has played out in some historic market sell-off events, in Figure 5 we have isolated five major global equity market corrections for the MSCI ACWI (since inception of the MDB Index in 2011). The chart highlights how MDB bonds have achieved moderately positive returns during four out of five episodes, confirming its diversification properties. 

    One of the most prominent example being the 2020 covid-crisis where, opposed to the -33% of MSCI ACWI, the MDB Index had a +2.7% return.

    Florian Cisana
    Head UBS ETF &
    Index Fund Sales Nordics

    Out of the five cases, the only example where, during the equity market sell-off, MDB performed negatively has been 2022. The main reason for this exception is that in 2022, the equity drawdown coincided with a global monetary policy tightening (rate hiking cycle). Intuitively, because of interest rate risk, when market interest rates rise the prices of fixed-rate bonds fall, causing negative returns. 

    This explains why, along with MSCI ACWI, both the MDB Index and US Duration-Matched treasuries performed negatively during the period. Besides the recent negative performance, the chart showcases how the MDB index performed broadly in line with US Duration-Matched treasuries even during market-stress periods. This confirms that MDB have similar risk-return characteristics to US treasury, and therefore belongs to the safest component of the Asset Allocation.

    Conclusion

    Bonds of Multilateral Development Banks represent a sustainable investment opportunity in high-grade USD denominated debt. Thanks to their high credit ratings, they can be considered a liquid and low-risk form of impact investing. MDB bonds also offer true global diversification given the unique reach, breadth and variety of MDB activities across most of developing countries. 

    Additionally, in the long-run multilateral development banks have shown similar risk-return characteristics compared to US Treasury and also offered good historical returns thanks to the liquidity premium offered.

     

    Image courtesy of Rawpixel Ltd.

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