Investors seek to tighten SLBs

IFR 2426 - 26 Mar 2022 - 01 Apr 2022
6 min read
Julian Lewis

Investors and analysts are moving to reshape sustainability-linked bonds’ development with new proposals on pricing and structure. Research from Federated Hermes and Anthropocene Fixed Income Institute is seeking to instill more rigour into a booming, complex product sometimes accused of lacking ambition in the embedded environmental and social targets.

Sales of SLBs have soared from around US$10bn in 2020 to some US$100bn last year, according to Refinitiv data.

The initiative follows recent debate over key performance indicator resets when issuers make major acquisitions. While accepting the need to set new baselines for companies after transformational deals that make reaching their SLB targets more challenging and increase the risk of triggering the product’s step-up coupon, some investors argue that the proposals should also include resets if issuers undertake M&A that makes meeting their KPIs easier.

In addition, investors such as Columbia Threadneedle and JP Morgan Asset Management are seeking to define best practice over callable SLBs. These are mainly a feature of high-yield versions of the product.

“To mitigate the risk of a greenwashing taint, a change in the structure needs to happen. And it's happening as a result of the buyside now participating in the conversation that has historically been between banks and companies,” said Mitch Reznick, head of research and sustainable fixed income at Federated Hermes, who also calls for “increased scrutiny” of SLB KPIs and targets.

“There’s a lot of people who’ve been out saying essentially the same thing,” said Ulf Erlandsson, chief executive at AFII. “[Introducing more rigorous financial analysis to SLBs] will help the robustness of the structures.”

Paper trail

Both Federated Hermes and AFII have recently challenged the developing SLB status quo through new research papers. The former, a leading institutional investor that manages nearly US$675bn across asset classes, is proposing a new model for pricing SLBs’ step-up option.

It argues that SLBs’ standard 25bp penalty for missing sustainability targets is “untenable and unhealthy” for the fastest growing ESG bond product since it fails to distinguish between large and small issuers.

In its new report (“Do sustainability-linked bonds have a step-up problem?”), Federated Hermes argues that “the materiality of [a fixed 25bp step-up] as an incentive is inconsistent across companies, and thus undermines credibility of the market".

“For some, it could actually be quite an incentive to hit the targets. For others, it's meaningless. A lot of companies wouldn't even notice 25bp,” said Reznick.

Instead, the firm argues for a sliding scale step-up. This should “flex with the scale of the issuing company” while also not pressuring cashflow so much that triggering it would increase credit risk and, in the worst case, create a secondary ESG risk by weakening the issuer – undermining its sustainability strategy and potentially even creating social problems.

The scale treats 5% of Ebitda as a more appropriate penalty and applies the proportion of SLBs in its debt capital structure to this. For an issuer such as France’s Rexel with around half of its debt in SLB format, this would have the “eye-opening” effect of increasing the step-up payment on €1bn of bonds to €24.3m from €2.5m.

The impact is rightly greater for larger companies, said Reznick. They “probably are the companies that you want the most to deliver into their sustainability objectives because they're, by their sheer scale, the ones that are going to have the most impact. And the value chain follows where the larger companies are moving.”


Meanwhile in its paper (“An option pricing approach for sustainability-linked bonds”) AFII proposes the use of options pricing to inform debate around SLBs. It sees scope for the product to work in the same way as convertible bonds by allowing issuers to drive down their cost of capital through the sale of an embedded option (in SLBs’ case, on their sustainability performance) – but this reduction must be earned through ambitious targets, comprehensible KPIs and more demanding step-ups.

“Then SLBs start becoming like a real transition financing instrument that has macro significance,” said Erlandsson, citing the important potential for fossil fuel issuers to access cheaper funding by using “a real penalising coupon” to ensure their commitment to strict and aggressive transitions.

He gives the example of a coal-exposed company offering a 4% step-up on an SLB with a 4% coupon.

However, AFII laments that some SLBs use such non-standard and opaque KPIs that they must be treated as “non-priceable”. These deals can be valued only with proxies and high degrees of uncertainty.

“We want the market to make a distinction between what's priceable and what's non-priceable,” said Erlandsson. “That will drive the evolution towards people wanting to build priceable structures, which would be more robust with better data and longer time series.”

Despite its criticisms, the institute already sees examples of good practice, added Stephanie Mielnik, AFII's director of research. She cites the recent landmark debut sovereign SLB from Chile, pointing to its separate step-ups for both of the two KPIs. An uncommon feature in corporate SLBs, this allows investors to price the probability of each target being met without having to also calculate correlation between the two – which becomes particularly difficult if one is in AFII’s “non-priceable” category.

Mielnik also praises Chile’s use of an absolute greenhouse gas emissions target. Since ample historical data are available for this KPI, its probability is easier to determine.