Growing pains for SLB market as coupon step-ups loom

IFR 2471 - 18 Feb 2023 - 24 Feb 2023
6 min read
Tessa Walsh

The sustainability-linked bond market is facing a significant moment as a host of issuers look like they may miss ESG targets and be forced to pay coupon step-ups on their bonds, potentially marking a new phase in the market's development that could feel uncomfortable for companies that have to pay up.

But far from providing a setback for the market, some observers say the debate around step-ups is an essential part of the market’s evolution.

“An SLB market without bonds that actually trigger would be a pretty meaningless market, or putting it even further, a market that would be proven to have no ambitions in its targets,” said Ulf Erlandsson, chief executive of the Anthropocene Fixed Income Institute, an advocacy group pushing to decarbonise financing. “The triggers we see, and expect to see, are a sign that the instruments work, rather than the opposite.”

There are currently around 150 index-eligible SLBs outstanding from nearly 100 issuers, and 20 SLBs with observation dates in 2022 and 2023 are facing possible coupon step-ups as a result of missing targets, according to a report from analysts at Barclays.

Polish oil refiner PKN Orlen was the first company to experience a coupon step-up when its MSCI ESG rating was downgraded last year. However, the deal was denominated in zlotys and was not an index constituent so the breach did not attract widespread attention.

While most SLB observation dates occur in 2025, five SLBs had an observation date at the end of 2022 and another 15 have observation dates at the end of 2023, the Barclays analysts said.

Of the five SLBs with observation dates in 2022, two companies met their targets at the end of 2021, which leaves Italian utility Enel, Greece’s Public Power Corp and Dutch chemicals company Nobian as issuers of the first index-eligible bonds that may have to pay step-ups. Enel risks breaching its 2023 emissions goal on nine of its bonds after the Italian government moved the country’s energy generation back towards coal as a result of the war in Ukraine, although that prospect didn’t put off investors from buying new bonds from the issuer last week.

The average cost to an issuer of a missed target over the lifetime of each SLB is US$9.4m, Barclays said.

The companies will reveal the results in sustainability reports published between February and April, while 2023’s vintage, including deals from German braking systems manufacturer Knorr Bremse and French water company Saur, have observation dates in late 2023.

AFII also identified Enel and PPC as being at risk of missing its targets and said that the war in Ukraine was a contributory factor due to changes in their energy generation mix, which is also an issue for deals with 2023 observation dates.

“This is a fairly isolated – and hopefully temporary – policy reaction, affecting a limited set of issuers and SLBs,” said Jo Richardson, head of portfolio strategy at AFII.

Quality control

The likelihood of companies paying coupon step-ups will reignite the long-running debate about the quality and ambition of targets that determine the probability of step-ups and ultimately the financial value of each SLB. The conversation around the issue also stands in contrast to the way the private sustainability-linked loan market quietly buries such news.

SLBs currently trade in line with conventional bonds, as investors are unsure about the quality or value of the embedded options, but greater ambition could eventually provide higher option premiums that would reward issuers for stretching goals.

Investors are calling for tougher targets and bigger penalties as the 25bp step-up that companies routinely pledged in a low or negative-yield environment look increasingly insignificant when yields are 4%–5% or more. But issuers are not seeing any financial benefits yet.

"As investors have become more sophisticated and demanding with regard to the scale of ambition within SLBs, there's something of an asymmetric risk-reward for issuers," said Philip Brown, global head of sustainable debt capital markets at Citigroup.

“Investors are asking issuers to pay a bigger penalty to reflect rising rates, but they're not necessarily compensating them with better pricing at the time of issuance.”

Still, Erlandsson remains optimistic about the outlook for SLBs. “We expect that discrepancy to adjust over time as the market adjusts to higher rates,” he said.

Falling volume

Only US$9.24bn of SLBs have been issued so far this year, which is 34% lower than the US$14bn issued at the same time last year. Volume has been falling since 2021 when a record US$91.23bn of SLBs were issued, with a steep drop observed in the second half of last year, according to Refinitiv data.

A total of US$63.1bn of SLBs were issued in 2022, a 31% drop from 2021. But in a tale of two halves, the US$44.6bn of SLBs issued in the first half of last year slumped 59% to US$18.45bn in the second half.

SLBs have taken a back seat as questions about the quality of SLBs and the ambition of their targets leaves investors open to possible greenwashing allegations, unlike green bonds, which are considered as sustainable investments under the EU's Sustainable Finance Disclosure Regulation.

The analysts at Barclays expect SLB volumes to recover to US$90bn this year, close to 2021’s record issuance, and other market players are expecting a rebound, particularly as high-yield issuers start to return.

"The slowdown in SLBs in the second half of 2022 was notably driven by high-yield issuers that didn't come to the market as much," said Agnes Gourc, head of sustainable capital markets at BNP Paribas.