Potential issuers of sustainability-linked bonds are trying to steer the market towards a model that lowers their cost of funding if they hit sustainability targets, instead of paying investors more if they miss them. But investors are unsurprisingly resisting the idea.
Most SLBs include a step-up coupon where investors are compensated with additional margin if the issuer fails to meet its key performance targets by a certain date. But bankers say issuers are now exploring step-down coupons in SLB transactions, where the coupon drops if a borrower hits its targets.
Proponents of the idea say that a step-down coupon is a better way of aligning a company's funding with its ESG goals. Such a structure might also help bring sovereign issuers into the SLB market.
"If we look at what we see in the corporate market, the main precedent is a step-up only," said Anjuli Pandit, UK head of corporate sustainability at BNP Paribas. "It’s fine to take that money from a corporate because it is coming out of profits of a corporate ... But for a sovereign that money is literally money being taken away from the taxpayer, which leads to a much greater reputational risk."
If a sovereign chose to issue a note with a step-down – as well as or instead of a step-up – it would mitigate that issue, she added.
There is certainly interest in such a structure among corporate issuers. But so far none have been willing to test the water in the US dollar or euro bond markets.
"I don’t think people are interested in being the first to try something like the step-down coupon because if investors throw up all over it then your deal could go badly," said the head of sustainable finance for a bank in New York.
German financial Berlin Hyp recently included a step-down feature in its sustainability bond framework. But when it launched its 10-year SLB in mid-April it chose to issue the deal with a single step-up coupon of 25bp if it misses its sustainability targets, which are tied to the carbon intensity of its loan portfolio.
"As SLBs are new to the fixed-income market we intended to create a simple structure which is easy to understand and offers as little complexity as possible when it comes to the integration of SLBs into the IT systems of investors," Bodo Winkler-Viti, head of funding and investor relations at Berlin Hyp, told IFR. "Investors are already used to SLBs with step-up coupons but not to the step-down feature."
Other issuers, mostly in Europe, have explored similar structures, which are already a common feature in the loan market.
“Syndicate desks, capital markets, and issuers are looking at it and discussing it with investors. But there has not been a level of interest where I believe you’re going to have a successful offering if you bring it to market,” said Scott Roose, head of ESG DCM in North America at Credit Suisse.
Getting investors onside will be the key challenge. "To me, it’s more logical that you have a step-up," said Denise Simon, co-head of EM debt with Lazard Asset Management. "For the borrower, the idea is that if they are more sustainable and can meet those targets they should generally be able to bring their borrowing curve down over time and they should improve as a credit ... I think the step-up is more realistic and I think a step-down would not necessarily align those incentives."