Investor Appetite

Forest-backed bonds are of interest to a broad range of potential investors - philanthropic, developmental through to pension funds - principally because of the range of benefits that sustainable forest management offer.  However, investors need to be fully convinced that the returns offered reflect the underlying risk of default and/or encompass their organisational mission/goals.  There are potentially a number of different bond structures, each likely to accommodate a range of investor profiles.

Asset-liability matching

Long-term investors with an interest in matching their liabilities against secure assets, such as pension funds and insurance companies, are the primary buyers at the long term (30+ year) duration proposed for forest-backed bonds.

A call for tighter disclosure by pension funds has left a global shortfall of long-duration assets of around $2 trillion [1].  Pension funds face the potential long-term risk of future liabilities that are not matched by future assets.

Performance Risk & Risk Mitigation

A number of factors could potentially influence the overall performance of a forest-backed bond but the most significant is the security and performance of the underlying forest asset.

Technically speaking both the political and physical risk associated with tropical forests could be managed within a forest bond structure.  Risk could be mitigated structurally, through portfolio diversification or externally through a third party provider such as an insurance group (e.g. in theory the World Bank Multilateral Investment Guarantee Agency, MIGA, could be well positioned to cover against the long term political risk associated with investment in tropical forest management).

Initiatives aimed at improving forest governance at a national level, in particular the EU FLEGT programme, have the potential to significantly reduce the long term performance risk that tropical forest assets are exposed to.

Any national or international action by the certification body which implies potential loss of certification on otherwise compliant forests is a less manageable and therefore more serious performance risk.

Whilst tropical forests show relatively predictable biological growth this generally does not translate into predictable cash flow.  Harvesting plans can be adversely affected by a range of factors including poor weather or local economic and political developments.  Timber prices can also vary widely over time.

Sustainable forest management combines income from certified timber with a range of alternatives, especially those for forest carbon.  The market for these alternatives is sometimes hard to quantify making their value and predictability of returns difficult to assess.

notes:
[1] ODDO Securities 2006. The irresolvable $2,000bn Pensions Conundrum.