SSAs slow to espouse SLBs

IFR SSA Special Report 2022
11 min read
Nick Herbert

Since the launch of the first sustainability-linked bond, the instrument has been warmly embraced by a diverse range of issuers. But SSAs have been notable by their absence. By Nick Herbert.

Sustainability-linked bonds are a relatively new member of the family of debt instruments tilted towards creating a carbon-free and socially just society. Unlike in the green bond market, however, which took a long time to reach critical mass, the adoption of SLBs has taken a different trajectory.

According to Refinitiv, from the first appearance of SLBs in 2019, volumes have risen dramatically. Issuance doubled in 2020 from the number registered in 2019, while in 2021 there was a more than tenfold increase over the year, with new supply reaching over US$91bn from 154 deals. The trend has been established.

“We continue to see a lot of a lot of interest in SLBs,” said Matt Kuchtyak at Moody’s ESG Solutions. “Our forecast for this year is another doubling of issuance to about US$200bn.”

Those forecasts were made in advance of the growth in inflation fears, tighter monetary policy and a deteriorating geopolitical environment, but Moody’s expectation is well on the way to being realised. Some 52 deals were launched by the end of April 2022, with over US$34bn in proceeds raised.

“The interesting piece about the SLB market is that, very early, there has been a diverse mix of issuers,” said Kuchtyak.

Issuance has been dominated by European corporates across a wide range of sectors. The clear attraction for these borrowers being that they get to use proceeds for general corporate purposes as opposed to funds being ring-fenced and directed to specific projects as with use-of-proceeds bonds.

The SLB structure also provides an additional level of flexibility to borrowers, in that they play a part in choosing the sustainability targets to which cost of capital is tied.

For many corporates, especially those without sizeable environmental and social projects to finance, SLBs are a more efficient route to gaining access to sustainable investors and the funds required to pay for the ESG transition. Nevertheless, a lack of projects is not normally a claim that can be made for SSAs, particularly the larger ones. To date, Refinitiv counts only three issues in the SSA space: local currency deals from Helsingborg in Sweden and Shiga Prefecture in Japan; and the whopping US$2bn 20-year international offering from the Republic of Chile.

Chile groundbreaker

At the beginning of March, with the Ukraine crisis unfolding, Chile took to the market with its ground-breaking offering through lead managers BNP Paribas, Credit Agricole and Societe Generale. The deal, with interest rates linked to absolute greenhouse gas emissions and share of non-conventional renewable energy generation in the national electric system, was priced to yield 4.34%, some 200bp over 20-year US Treasuries, with eventual pricing having compressed by 40bp from initial price talk, and resulting “in a greenium compared to a conventional issuance”, according to Credit Agricole.

The success of this first sovereign SLB was impressive given the war-induced market volatility, with investor enthusiasm evident in order books totalling US$8.1bn.

Other sovereigns have announced their interest in similarly using the SLB structure to tap the environmental debt market, but opinions are mixed as to whether they need to and whether it is a structure that lends itself well to other members of the sector.

“What is interesting to note is that the one example that we have of a sovereign issuing SLBs – the only example we have – comes from a sophisticated issuer,” said Myriam Zapata, SSA DCM ESG specialist at BNP Paribas. “An issuer who always wants to be ahead of the pack, not only in terms of capital markets products but also in terms of climate.”

Communicating sustainability

Issuing sustainable debt is a great way for borrowers to communicate to the broader market and stakeholders their climate and social ambitions. And with SSAs already at the vanguard of the green and social bond movement, it is arguable that they need another instrument announcing their intentions – especially when there are already alternatives in place that provide sufficient flexibility to accommodate a variety of projects.

Most of the major borrowers have already established a reputation in the use-of-proceeds market, already have long-term socially responsible investor relationships and already have the infrastructure in place to cope with the demands of choosing appropriate projects, allocating proceeds, data collecting and providing annual reports. For many, everything they do is already aligned to the task of sustainability.

“For most MDBs, we’re already performing to our mandate,” said Isabelle Laurent, deputy treasurer and head of funding at EBRD. “And, by definition, our mandate is all about sustainability, whether that is tackling poverty or focusing on the transition to market economies in both an environmentally and socially sustainable way.”

SSAs already have a system in place to communicate their environmental and social credentials and there is little need to adopt another instrument to reinforce their level of commitment.

“Everything we do is sustainability linked,” said Laurent. “Our lending is not for general capital purposes and it’s normally inherent in our project lending that we're looking to achieve specific targets. Many investors can buy any and all of our bonds as sustainable bonds and we will report in a way that investors already appreciate.”

There is nothing inherently in the SLB structure that precludes its use by SSAs, however, and there are many examples in the corporate sector where borrowers are issuing use-of-proceeds bonds as well as bonds with a sustainability link.

Size matters

For some SSA borrowers, issuing SLBs may have some advantages and there will be more examples of this sector using the instrument. The relevance of the product to sovereigns has been explored by Fiona Stewart, lead financial sector specialist at the World Bank, who, along with Rachel Mok, authored a report, Striking the Right Note: Key Performance Indicators for Sovereign Sustainability-Linked Bonds.

“One of the reasons several countries are interested in SLBs, particularly some of the smaller ones that have already run out of projects they can tag as pure green, is the attraction of having something that is general use of proceeds rather than ring-fenced but also commits to really strong outcomes,” said Stewart.

“We want to see outcomes as well as outputs,” she said. “Green markets are nice, but what really has the potential to move the needle are these performance-type instruments.”

Nevertheless, there are still challenges for the SLB market to overcome, as there are questions about the structure’s robustness in general and for sovereigns in particular.

Stick, carrot and risk

“We like the concept of linking a coupon to specific targets but the challenge is really how to set standards to make it a credible market,” said Bram Bos, lead portfolio manager of the green bonds team at NN Investment Partners. “It's a big question for investors – whether the issuer happens to be a corporate or an SSA.”

Points of debate with the structure include: the choices of credible key performance indicators, ones that are relevant to the issuer and the ESG transition; the level of ambition within KPIs; measurement; and when the targets are measured. The extent to which the cost of capital is linked to targets is also questioned.

“Should the coupon step up in the last year of maturity or should it be halfway through the bond’s lifetime?” said Bos. “Should the step-up be 25bp or 100bp, or should the coupon step down?”

And perhaps those questions are uniquely relevant to sovereign issuers, where the government needs to respond to and have responsibilities to taxpayers. There is also a layer of political risk in judging whether there is the will to reach targets when governments are likely to change before the bond matures.

“These instruments are interesting because any future government is incentivised to reach targets, otherwise they will have to explain themselves to voters,” said Zapata. “If they have not reached them, they will have to pay up.”

Stewart contends that a step-down coupon might be more appropriate to lesser credits.

“For lower credit ratings, for those borrowers that have a harder time getting to market, you might want to see a step-down,” said Stewart. “In that way, they really get rewarded for having ambition.”

Direction of travel

While many SSAs will eschew the SLB market in the near term, relying instead on the work they have put in with the use-of-proceeds market, the notion of rewarding borrowers for reaching ambitious and measurable targets is appealing.

“It’s where the market is going,” said Antti Kontio, head of funding and sustainability at Municipality Finance. “I like the idea of it – getting some kind of benefits for hitting targets. But most issuers, like we do, have history in the green bond space, and it’s a bit difficult to keep bringing new products to market every year.”

Nevertheless, Kontio does not rule out using them in the future.

“I expect SLBs will make an impact on us in the next five to 10 years, but I don't see us using the product in the very short term,” he said.

Ultimately, whether to issue use-of-proceeds bonds or SLBs comes down to personal choice and the objective of the exercise.

“I think SLBs are a good instrument to highlight to investors and the broader community the extent of a borrower’s climate ambitions and by when they are to be achieved,” said Zapata. “And I do think that there is room for large issuers to also use the instrument. We hope any concerns can be overcome and that we’ll see other issuers follow Chile to the market.”

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