Investors in World Bank's 'pandemic bonds' face heavy loss

Two World Bank-issued "pandemic bonds" are facing big loss, which has fallen under the spotlight as the coronavirus outbreak continues to spread worldwide.

These bonds were designed to pay out funds to countries that need help to contain a pandemic and was issued by the World Bank's International Bank for Reconstruction and Development (IBRD) in 2017, CNBC reported.

Earlier this month, the World Health Organization (WHO) classified the current coronavirus outbreak a global pandemic.

However, the bonds offer investors high interest payments in return for taking on the risk of losing a certain amount or all of their money if pandemics occur. 

But prices of those bonds have plunged as investors flee with the number of COVID-19 cases surging. Growing fear about the economic fallout of the outbreak has driven a sell-off in risk assets as investors seek the perceived safety of government bonds like US Treasurys.

According to ratings agency DBRS Morningstar, investors who hold the riskier of the two bonds could be losing their entire principal amount soon, with the firm telling CNBC that the price should have dropped more than 80%.

Pricing for the less risky bond has probably fallen less than 50%, said Marcos Alvarez, senior vice president and head of insurance — global financial institutions at DBRS Morningstar. Pricing information on these bonds is not public as they were privately placed three years ago.

"Similar to other catastrophe-linked bonds in the market, investors could lose their principal if a set of parametric triggers, such as outbreak size, growth rate and spread across borders, are met," the firm wrote in a report earlier this month.

According to the World Bank, the outbreak would need to last at least 12 weeks, and have more than 2,500 deaths for the riskier of the two bonds, and 250 deaths for the other. There must also be more than 20 deaths in a second country.

When all those conditions are fulfilled, it triggers a payout to selected countries in need of help to contain the outbreak, and investors lose some or all of their money. That date works out to be Mar. 24, going by the 12-week period, and the start date of the outbreak — Dec. 31, according to the WHO, said DBRS Morningstar.

The World Bank did not respond to CNBC's request for comment.

Globally, there are at least 184,976 cases and 7,529 deaths, according to the latest data from the WHO.

"You have the risk out there, we have the coronavirus out there. But you look at the last 50 years, you have SARS, you have MERS, you have Ebola, it's not that rare. It happens," says Amiyatosh Purnanandam, professor of finance at the University of Michigan.

What are the World Bank's pandemic bonds?

Pandemic bonds are essentially debt that's tied to catastrophic events, designed to raise money for issuers if natural disasters occur.

Investors typically buy catastrophe bonds because they offer much higher yield than other fixed income products. They also aren't linked to the usual stock market performance — but are instead tied to disaster events — and hence offer investors' portfolios some diversification.

But DBRS Morningstar cautioned: "The typical investor in catastrophe bonds is attracted to this asset class because it is generally uncorrelated with the general markets; however, the current coronavirus outbreak is showing that the valuation of pandemic bonds is highly correlated with the performance of global financial markets when it matters most."

Stock markets have been very volatile since the outbreak rapidly gained pace this month, with the Dow having its worst decline on Monday since the "Black Monday" crash 30 years ago.

On Monday, the Cboe Volatility Index closed at a record high, topping its peak during the 2008 financial crisis. The index looks at options prices for the S&P 500 and is sometimes referred to as the "fear gauge" of Wall Street.

More details about the World Bank's pandemic bonds:

Two bonds worth a total of $320 million: Dubbed Class A and the riskier Class B.

Interest payments: Class A dishes out interest payments of 6.5% plus 6-month US dollar Libor rate. Class B pays out 11.10% plus 6-month US dollar Libor rate. These interest payments are funded by donor countries including Japan and Germany.

Viruses covered: The six that are "most likely to cause a pandemic," the World Bank said, which could trigger a payout to countries — Influenza, coronaviruses, Filovirus, Lassa Fever, Rift Valley Fever and Crimean Congo Hemorrhagic Fever.

Countries that could receive that payout: 76 countries are eligible for funding under the World Bank's International Development Association.

If that payout is triggered, that's when investors stand to lose their money. For investors of Class A notes, that loss is 16.67% of their principal amount, while those invested in Class B notes stand to lose everything.

Investors in those bonds reportedly include French asset management firm Amundi, and U.K.-based asset manager Baillie Gifford. According to DBRS Morningstar, the bonds are owned by asset managers, pension funds, among others. Investors are mostly based in the US and Europe.

The bonds were more than 200% oversubscribed in 2007 when they were issued.

Bonds under fire

Despite the stated basic parameters, critics say that it's not that simple to determine when a pandemic can trigger a payout. And even if that happens, it may be too late for countries that need help.

"Similar to other catastrophe bonds, defining parametric triggers is not an easy task and IBRD pandemic bonds are no exception," said DBRS Morningstar, pointing to its 400-page prospectus. "Another objection from public health experts is that pandemic bonds are not designed to help poor countries prevent an outbreak as funding might be available too late."

Purnanandam added: "The pandemic bonds were supposed to help the countries fight infectious diseases, but there have been some serious issues with the way the contracts were designed."

"By the time bond investors will pay money towards ... the developing countries ... It's a case of too little, too late because the way these contracts are designed, they are too complex," he said.