Natural Selection: Evaluating Debt-for-Nature Swaps

ESG in Action

Investors are becoming increasingly aware of the importance of biodiversity and the urgency of preserving our planet’s natural capital—the stock of natural resources that underpin our economy and society, including minerals, soils, air, water and all living organisms. In response, bond issuers are launching more conservation-linked bond structures that can help indebted developing countries protect their vulnerable ecosystems. These structures require careful evaluation.

Understanding Debt-for-Nature Swaps

Debt-for-nature swap deals restructure developing countries’ foreign sovereign debts, cancelling or reducing outstanding bond issues on condition that part of the debt relief is used for nature conservancy. The swap deals are best suited to countries at risk of defaulting on their debt payments; their bonds trade well below face value, making a buyback a cost-effective way to reduce a country’s aggregate debt burden. With an improved fiscal position, the country can commit to a meaningful environmental investment schedule funded by new issuance of conservation-linked bonds.

The swap mechanics vary and can be complex. But in our view, two components are essential for a successful transaction: a significant share of debt relief redirected to nature conservancy, and a satisfactory yield for investors in the conservation-linked bonds.

Comparing Different Structures

Recently, we’ve seen two debt-for-nature swap deals from very different sovereign issuers: Ecuador (supporting the Galápagos Marine Reserve), followed by Gabon (financing a new coastal Marine Spatial Plan).

The US International Development Finance Corporation (DFC), the US government’s development institution, helps protect both conservation-linked bond issues against nonpayment by the borrowers. Consequently, both issues received AA-equivalent credit ratings that helped substantially reduce funding costs. By contrast, Ecuador’s and Gabon’s sovereign debt is rated CCC. Both conservation-linked issues were also small, were priced competitively and helped shift government spending towards biodiversity conservation efforts in marine areas. That’s where the similarities end.

The effective amounts of debt relief and resulting cash-flow benefits differed significantly. Gabon’s foreign debt traded at 85 to 97 cents on the dollar, compared with just 40 cents for Ecuador’s. Buying back Ecuador’s bonds at such a deep discount made the debt relief much cheaper to fund and gave the Ecuadorian government far more potential to finance conservation efforts.

Under the terms of the Galápagos Marine Bond agreement, Ecuador will spend more than US$323 million on marine conservation over the life of the loan—equivalent to about 50% of the US$656 million issue proceeds. That compares with the roughly US$125 million committed for conservation by Gabon, representing about 25% of their US$500 million conservation-linked bond.

In addition to providing a much bigger share of environmental funding, the Galápagos bond covers a much larger geographic area and includes stronger environmental protections. These include 18 discrete commitments to monitor and manage sustainable fishing practices, from implementing vessel monitoring systems to reducing the use of drifting fish-aggregating devices to specifying reporting protocols.

We also scored Ecuador materially higher than Gabon in terms of alignment with environmental, social and governance best practices and UN sustainable development goals. Limits to political freedom were a notable governance factor; according to the Economist Intelligence Unit (EIU), Ecuador is a hybrid democracy, while Gabon is an authoritarian regime (Display).

Current analysis does not guarantee future results.
As of August 14, 2023
Source: AllianceBernstein (AB)

Engaging for Better Outcomes

Based on our favorable analysis for Ecuador, we engaged* with their bankers.

We appreciated the scale of their deal’s financial benefits, its robust structure backed by multiple stakeholders, and the important environmental benefits for the Galápagos Marine Reserve, one of the largest and most biologically diverse marine protected areas on Earth.

Our engagement also helped secure a significantly higher yield than the average for bonds issued by US corporates with comparable AA ratings. In fact, the Galápagos bonds yielded more at issuance than single-A bonds. We required this premium partly because of the bonds’ idiosyncratic features and partly because of the illiquidity and early stage of development of the debt-for-nature swap market.

Following this successful interaction, we are engaging with other countries and financial counterparties to assess whether the structure can be replicated elsewhere. The Task Force on Sustainability-Linked Sovereign Financing for Nature and Climate, an initiative launched recently by development finance institutions on the sidelines of the UN Framework Convention on Climate Change (COP28), also aims to scale up the size and number of debt-for-nature swaps.

But irrespective of previous deals and potentially increasing issuance, investors should conduct rigorous due diligence on each new debt-for-nature swap, scrutinizing both the viability of the underlying nature projects and the financial and other credentials of the governments involved.

For a deeper dive into this and other key topics around biodiversity, read our white paper, “Biodiversity in the Balance: How Nature Poses Investment Risks and Opportunities.”

*AB engages issuers where it believes the engagement is in the best interest of its clients.

INVESTMENT RISKS TO CONSIDER

The value of an investment can go down as well as up and investors may not get back the full amount they invested. Capital is at risk. Past performance does not guarantee future results.

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