According to the report by global credit ratings business DBRS Morningstar on Tuesday (3 March), payouts for USD$132.5 million (S$183.86 million) will likely be issued in the form of pandemic catastrophe bonds which are sponsored by the World Bank Group’s (WBG) Pandemic Emergency Financing Facility (PEF). This issuance is in response to the ongoing COVID-19 outbreak globally. Eligible countries will be the recipient of these funds which will allow them to cushion the impact of the virus as well as possibly paving the way for market-based mechanisms to deal with pandemics, the report stated.
The DBRS Morningstar report addresses three matters. The first is the history behind the funding mechanism of the PEF and the organisations involved. The second highlights the two windows which are the channels through which PEF funds are distributed to eligible countries as well as the exposition on the two classes of pandemic bonds. The third is the future outlook of the pandemic bond markets. Below is the summary of the three matters.
The Pandemic Emergency Financing Facility
The International Bank for International Reconstruction and Development (IBRD) was formed in 2017 as part of the WBG, in response to the cross-country West African Ebola outbreak in 2014-15 which took the lives of more than 11,000 people. Due to this, an established funding mechanism became more imperative to combat pandemics in developing nations, the report suggested.
In partnership with the World Health Organisation (WHO) and other private and public organisations, the International Development Association (IDA) and the IBRD established PEF as a means to provide more funding for eligible countries to help them prevent and combat disease outbreaks from turning into spreading pandemics. The IDA is also part of the WBG whose mission is to combat extreme poverty in the world’s poorest countries.
In general, countries that are eligible to receive financial aid from IDA are also those who have access to the PEF, the report notes. One mission of PEF is to provide additional financing to the poorest countries, while complementing the assistance that also come from IDA, international donors, and organisations to support and manage large-scale, cross-border pandemic outbreaks.
One use of the PEF funds is to finance the cost of response effort in dealing with an outbreak. This encompasses, among other things, disease management efforts such as the deployment of human resources, drugs and medicines, essential and critical lifesaving medical equipment, personal protective equipment, logistics and supply chain of critical supplies, non-medical equipment, minor civil works (e.g., setting up temporary attention centres), services, transportation, hazard payments, and communication and coordination.
The Insurance Window and Two Classes of Pandemic Bonds
There are two windows through which PEF funds are channelled to eligible countries, which are (1) cash window and (2) insurance window. Both windows serve to complement one another and they are triggered in different ways. For example, to combat Ebola in the Democratic Republic of Congo, the PEF has provided USD$61.4 million (S$ 85.22 million) from its cash windows and this includes the USD$ 50 million (S$69.41 million) for the current 10th outbreak.
As for the insurance window, it offers coverage of up to USD$425 million (S$589.99 million) which comprised of two classes of pandemic bonds for $320 million (S$ 444.23 million) in floating-rate catastrophe-linked capital at-risk notes issue as well as pandemic-risk-linked swaps for $105 million (S$ 145.76 million) in June 2017 (see Exhibit 1).
The totals for Class A and Class B pandemic bonds were USD$225 million (S$ 312.38 million) and USD$95 million (S$131.89 million). Like other catastrophe-linked bonds in the market, during the situation where a set of parametric triggers, like spread across borders, outbreak size and growth rate, are met, investors could end up losing their principal. Exhibit 1 below shows the differences:
During the current time of outbreak, it is a possibility that investors in both classes of IBRD pandemic bonds will lose part or all of their principal investment based on the newest statistical information and conditions laid out in the prospectus of these pandemic bonds provided by the WHO. Despite this, the report predicts that investors that are more likely to be affected and suffer higher proportional losses in their principal are Class B investors.
Under the standards of IBRD’s pandemic bonds, an outbreak must meet a certain level of severity from the aspects of growth rate, event duration, geographical spread, and number of confirmed cases for it to be classified as an eligible event.
To be classified as Class A, the current outbreak will have to meet the conditions of (1) cause more than 2,500 fatalities in countries and territories specified in the prospectus with 250 cases confirmed on rolling basis, (2) last at least 12 weeks, and (3) cause more than 20 fatalities in a second country. Class A Notes would suffer losses of USD$37.5 million (S$52.06 million) or 16.67% of principal if the conditions are satisfied. This amount will be distributed by PEF among specialized international agencies and government of certain countries. COVID-19 outbreak has met the conditions as Class A Notes in terms of geographic spread and number of deaths, according to the newest date by the WHO. Nonetheless, because the commencement of the outbreak has been dated on 31 December 2019 by the WHO, the bonds will be paid on 24 March 2020 after the 12-week duration period.
To be classified as Class B, less fatalities need to be triggered (250 deaths) whereas the remaining conditions are materially similar to that of Class A. The primary difference would be the loss of all principal the amount USD$90 million (S$124.95 million) on March 24, 2020 based on Exhibit 2 below. Based on the current development, the PEF distribution amount available will be USD$132.5 million (S$183.96 million). Nevertheless, due to the higher risk of Class B Notes, there is a larger coupon as compensation.
Pandemic Bonds Market Outlook
The current total catastrophe bonds valued at USD$37 billion (S$ 51.37 million) is made up of a small proportion of IBRD-issued pandemic bonds valued at USD$320 million (S$444.27 million). The last issuance of IBRD pandemic bonds was in 2017 with an oversubscription of over 200 per cent. Like other catastrophe bonds, defining parametric triggers for pandemic bonds is a difficult task, with a prospectus of close to 400 pages.
The different types of pandemics alongside the complicated definition of trigger events have made the valuation of pandemic bonds very difficult. Sophisticated institutional investors are mostly the ones who buy catastrophe bonds, as shown by Exhibit 3 below:
This asset class of catastrophe bonds attracts typical investors due to the fact that it is usually not correlated with the general markets. Nonetheless, the performance of global financial markets does show high correlation with the valuation of pandemic bonds, as evidenced by the impact of COVID-19.
Comparing pandemic bonds and catastrophe bonds, the report highlights that pandemic bonds are issued to address shocks which produce a much more global impact whereas catastrophe bonds address shocks such as hurricanes or earthquakes whose impact is more focalized and less susceptible to changes in overall global market.
Pandemic bonds may not serve its purpose to help prevent outbreak in poor nations because funding availability can be too late, as criticised by public health experts. Also, they pointed out that pandemic bonds have high-interest coupons which make them quite expensive and that these funds can be used as investment in the health sector infrastructure of developing nations.
Nonetheless, the aim of pandemic bonds is to introduce marked-based funding tools to distribute some risk to the financial markets and not take the place of other development aid programs.
In the midst of complaints during the beginning stages of the outbreak about pandemic bonds not being paid out, the report notes that the pandemic bonds will be triggered soon and the resources from this principal write-off will assist the poorest countries combat the outbreak.
According to the report, whether investors will hold on to pandemic bonds after payouts are triggered remain to be seen. However, interest remained in pandemic bonds even after the impact of large natural disasters in the past. To ensure pandemic bonds as a viable funding source for high-severity but low-frequency pandemics and to address existing concerns, a second round of issuance can be helpful, the report concluded.