Commodity-linked bonds as an innovative financing instrument for African countries to build back better

Joseph Atta-Mensah; Joseph Atta-Mensah

doi:10.3934/QFE.2021023

Quantitative Finance and Economics

2021, Volume 5, Issue 3: 516-541. doi: 10.3934/QFE.2021023

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Research article

Commodity-linked bonds as an innovative financing instrument for African countries to build back better

Joseph Atta-Mensah ^,

Macroeconomics and Governance Division, United Nations Economic Commission for Africa, P. O. Box 3001, Addis Ababa, Ethiopia

Received: 16 January 2021 Accepted: 15 June 2021 Published: 17 June 2021
JEL Codes: F30, F34, F49, G13, G11, O16

Commodity-linked bond, a type of state contingent claims, presents an innovative tool for African countries to mobilize resources on the international capital markets. Given their colossal financing needs, which has been worsened by the COVID-19 pandemic, African countries need to put in place innovative financing mechanisms to support their development frameworks for building back better. The issuing of this type of bond could provide an opportunity for commodity-producing African countries to hedge against fluctuations in their export earnings. The results show that the value of a commodity-linked bond increases as the price of the commodity indexed to the bond rises, suggesting that African countries should issue debt contracts that are tied to their export commodities so that their debt declines with plummeting export prices (or export revenues). A simple portfolio rule derived suggests that countries should issue more commodity-linked bonds than conventional debt if the variance of the portfolio is greater than twice the spread between the expected total return of the conventional debt and the commodity-linked bond. This rule supports the view that African countries' debt-service payments, for debt issued in the form of commodity-linked bonds, would decline whenever the price of their export commodities decline thus lightening their debt load.
- innovative financing,
- debt,
- state contingent debt instruments,
- commodity linked bonds and option pricing,
- and building back better
Citation: Joseph Atta-Mensah. Commodity-linked bonds as an innovative financing instrument for African countries to build back better[J]. Quantitative Finance and Economics, 2021, 5(3): 516-541. doi: 10.3934/QFE.2021023

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Abstract

Commodity-linked bond, a type of state contingent claims, presents an innovative tool for African countries to mobilize resources on the international capital markets. Given their colossal financing needs, which has been worsened by the COVID-19 pandemic, African countries need to put in place innovative financing mechanisms to support their development frameworks for building back better. The issuing of this type of bond could provide an opportunity for commodity-producing African countries to hedge against fluctuations in their export earnings. The results show that the value of a commodity-linked bond increases as the price of the commodity indexed to the bond rises, suggesting that African countries should issue debt contracts that are tied to their export commodities so that their debt declines with plummeting export prices (or export revenues). A simple portfolio rule derived suggests that countries should issue more commodity-linked bonds than conventional debt if the variance of the portfolio is greater than twice the spread between the expected total return of the conventional debt and the commodity-linked bond. This rule supports the view that African countries' debt-service payments, for debt issued in the form of commodity-linked bonds, would decline whenever the price of their export commodities decline thus lightening their debt load.

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