mobilizing hybrid finance
Creating financial instruments that combine the characteristics of debt and equity is already a pretty common occurrence on Wall Street. I think we can repurpose them for public policy, too.
image: a U.S. government consol bond.
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July 1, 2024
Consols, cocos, and hybrid capital―technically, these are distinct financial instruments. But, for all intents and purposes, they’re functionally identical in their ability to creatively support long-term investments.
The obvious and eminently fair follow-up question here is: what the heck am I talking about?
The long story short is that these three instruments all combine the characteristics of equity investments (buying shares) and debt investments (making loans) to do what amounts to a “secret third thing”: provide those seeking investment with a source of long-term financing that is forgiving enough to accommodate their potentially volatile returns but consistent enough to promise some amount of predictable revenue stream to their investors. These hybrid instruments, despite the small differences between them, share the same form and function―a function which I’m thinking is perfectly worth drawing on to support and derisk longer-term investments in climate, energy, and social welfare.
Most discussion that I’ve seen around derisking investments in public-priority sectors centers on concessional debt, not concessional equity. Concessional debt is just that: debt, but at lower interest rates than private investors would charge and potentially carrying subordinate status in a bankruptcy. But there’s a growing conversation around the use of concessional public equity stakes, too. Lenore Palladino wrote this wonderful paper on the topic; in her words, “allocating and coordinating financing is as important to the successful achievement of development and industrial policy as the total volume of new investment.”
This creative intervention into what public equity can do is another great argument for why, as I’ve touched on in previous writing, the quality of finance provided to crucial investments matters as much as its quantity. And it’s that argument which I’m drawing on to ground my thoughts about the potential benefits of blurring the lines between equity and debt. Creating hybrid financial instruments is already a pretty common occurrence on Wall Street, but I’m not particularly sure that the possibility of adapting these instruments to public policy has really been fleshed out, at least not yet. That’s what I want to try doing here.
First, I’ll explain my three example instruments―consols, cocos, and hybrid capital. What are they, exactly?
Once I explain consols, the rest will be easier to understand. So let’s start there. Consols are perpetual government bonds that work like annuities: governments issue debt at a certain principal amount to bondholders and, in doing so, commit to repay bondholders at a fixed coupon rate in perpetuity. Put another way, consol bonds pay back only interest, not principal, but they pay interest forever. The British and American governments have used consol bonds before, throughout their histories. The last American consol was issued in 1900. (Lots of American economics bloggers have more recently floated the idea of using them to sidestep our periodic debt ceiling showdowns, on account of the fact that only the principal on government bonds, but not their interest costs, count toward the debt ceiling).
Many perpetual bonds are “callable,” meaning that their issuers can buy them back after a fixed period. Longer call periods―say, greater than 10 years―allow bondholders a fixed return on their investment for more time. Regardless of the period, the presence of a call option allows issuers the opportunity to refinance their perpetual bonds on better terms, particularly if interest rates have fallen. In this way, calling consols is akin to refinancing a mortgage. If interest rates rise, issuers can choose not to buy back their consols; call options are options, after all.
Consol bonds were so popular in the 18th century because, as the Congressional Research Service writes, “governments with major expenses due to war or other causes could not be certain when they could pay off or roll over debts. Perpetual debt instruments gave finance ministers more flexibility to choose when debt would be retired, rather than having to repay principal at a fixed maturity rate.” (And, “for households with means to invest, perpetual debt instruments and annuities provided a means to preserve buying power into the future or to avoid penury in old age.”) We’ll come back to these arguments later―I’m sure you can see immediately how they might be relevant to any judgment about their suitability to long-term investments.
Next, cocos, a cute abbreviation for “contingent convertibles.” They’re also known as “Additional Tier 1” securities, or AT1s, which were all over the news (I mean Money Stuff) when Credit Suisse collapsed, due to some misunderstandings among investors about the nature of the instrument. Cocos/AT1s are used for a very specific purpose: shoring up banks’ balance sheets to meet regulatory and risk management standards. On a normal day, they work a lot like consols, paying out a fixed interest rate to bondholders in perpetuity. But they’re structured in such a way that, when a bank’s capitalization falls below regulatory standards or when a bank’s share price falls under a certain threshold “strike price,” these perpetual bonds transform into equity shares. This transformation to equity usually works in one of two ways: either the cocos could be zeroed out such that existing shareholders see an increase in the value of their equity, or the cocos could convert directly into new common stock. Regardless, the result is the same: cocos buoy the bank’s balance sheet with some extra liquidity.
It would be fair to describe cocos as a “debt-for-equity swap” instrument, conditioned on a bank’s inability to remain adequately capitalized. While consols do not turn into equity―governments issue consols and banks issue cocos; their immediate purposes are different―both instruments give their issuers greater ability to weather the shocks they might face.
Hybrid capital instruments, my third example, are perhaps the most relevant. Staring down the challenge of meeting global investment needs with little forthcoming public funding, development policymakers across the G20 countries endorsed the African Development Bank’s push to issue hybrid capital instruments to buttress its balance sheet. Unsurprisingly, these hybrid instruments work a lot like consols and cocos―and they seem to have successfully “mobilized private capital.” The African Development Bank issued $750 million of these hybrid notes earlier this year, and the issuance was oversubscribed by $6 billion. The notes are callable after 10.5 years―but bondholders can redeem them, too, every 5 years from then on, sort of like if they were mutual fund investors with limited redemption windows. The Bank can write down these notes to zero anytime if it has to use its callable capital reserves, akin to the trigger condition on cocos. Apparently the private credit rating agencies treat these hybrid notes like equity shares, rather than debt instruments, thereby giving the Bank more “headroom” to issue debt. The Bank itself has pledged to use that headroom to help finance environmental and social investments―making these hybrid notes an instrument that the Bank can market as ESG-compliant to interested investors.
Each of these examples showcases how a unique debt-equity hybrid financial instrument helps insulate its issuer from the full impact of any potential future shock to its solvency. My theoretical anchor for this claim is Minsky’s financial instability hypothesis, which argues that the most stable financial actors are “hedge financing units” that “can fulfill all of their contractual payment obligations by their cash flows: the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit.” It stands to reason that equity-like hybrid instruments like perpetual debt can, if used right, stabilize balance sheets. And, because an economy dominated by hedge financing units is more stable, high interest rates or other economic shocks will not force asset sales or project cancellations as rapidly as they otherwise might. While there’s no issue in my mind with proposing that governments should buy out struggling projects, perhaps these hybrid instruments can prevent that from needing to happen in the first place. These instruments all help issuers build a more “correlated” capital structure: when the going gets tough, the tough can liquidate these hybrid liabilities in order to stick around. In the world of finance, after all, liquidity is resilience.
What are the use cases of perpetual bonds for public policy, beyond just buttressing the multilateral development banks?
Immediately, I think lots more green banks and development financing institutions could be issuing these hybrid instruments: not only do they promise to mop up demand from ESG-minded impact investors, but they also help these institutions weather the next decade of policy and revenue uncertainty better than conventional bond issuances would. Public financing institutions making big investments into the green transition are probably not going to be seeing much in the way of short-term profits, even if their returns stabilize later. Issuing hybrid instruments gives them the short-term flexibility and shock-absorption capacity that they deserve.
The African Development Bank’s successful issuance of hybrid capital notes suggests that investors are actually interested in holding those assets. But we shouldn’t count on it. Policymakers should insure themselves against the possibility that private demand is inadequate or drops off during market downturns. “Sudden stops” and fire-sales of securities happen all the time; it’s only prudent for policymakers to create some kind of broker-dealer to stabilize these new asset classes, to ensure that private markets can’t discipline public investment priorities. If we’re going to write hybrid instruments into our green banking playbooks, we’ll need the equivalent of a municipal liquidity facility to backstop them.
Going one step further, there’s no technical or legal reason, to my mind, why project developers can’t also use these perpetual bond structures when arranging their financing. I can imagine lots of cases where project returns are low and/or volatile in the short term but stabilize over the longer term. Take investments in merchant renewable energy, where returns right now will be more volatile at least until more batteries can balance the grid. Or nuclear projects, with long construction phases and multiple reactors going online years apart from one another. Or mines, where not enough construction is happening on account of the twinned facts that, first, it takes up to a decade to build a mine but, second, mineral prices and demand forecasts can’t be predicted with certainty so far in advance. All of these assets might need longer-term sources of funding to backstop any expenses for faster-than-expected wear-and-tear, regular maintenance, retrofits, and upgrades: many onshore wind turbines, for example, can and should be “repowered” to better serve the grid.
One big reason I think these are good project-level use cases comes from a book I recently read about the New Deal―Robert Leighninger’s Long-Range Public Investment. Great book, for what it’s worth. Leighninger mentions that the New Deal’s public housing programs, expansive as they were, remained out of reach of the poorest Americans in part because these housing programs had to be “self-liquidating” over their 60-year loan periods. In English, this meant that these projects could not be loss-making: federal loans to local housing authorities had to be fully paid back over 60 years. If the loan durations were longer, or if projects were given greater subsidy such that they did not need to be “self-liquidating,” then they could have housed more people, according to Leighninger. But imagine if these loans were perpetual bonds, whereby public housing authorities wouldn’t need to pay back the massive principal amounts on their loans over a fixed maturity. Perpetual bonds would effectively set loan durations at infinity; insofar as there will always be demand for housing, there is no way that these instruments would not be self-liquidating.
None of this is legal or financial advice―I know just enough about any of these sectors to argue that they all deserve financing on more forgiving terms, but not enough to claim that perpetual bond-type instruments are necessarily the best way to provide that. And they’re certainly not a replacement for public ownership or regulation where necessary. Palladino’s paper, which I mentioned above, puts it best: “the goal here is to consider how to design public equity stakes when they are appropriate, not to argue that they are appropriate where public ownership or public options may be a stronger solution to public provisioning of a good or service.” The same logic applies to my argument about perpetual bond-type instruments. Right now, I’m more interested in fleshing out the use cases for unique financing strategies rather than justifying their political efficacy.
To that end, I’m just thinking out loud. The private sector has all these weird financial instruments; there’s no reason not to adapt the more useful ones to public ends. A guy can dream!