Remedies needed to address misaligned incentives and lack of comparability in booming market, says ratings agency.
The market for sustainability-linked bonds (SLBs) has mushroomed in less than two short years from 1% of the sustainable bond market at the end of 2020 to 10% by the end of June 2022.
Such bonds offer an attractive flexibility for issuers on how proceeds are spent, while investors are promised increased coupon payments should the issuing entity fail to meet the sustainability targets it has set itself.
But a new report from Sustainable Fitch, the ESG arm of the credit rating agency, highlights the problems of SLBs, as well as their ever-growing popularity.
These include a lack of price differentiation among issuers of different quality, the moral hazard arising from the fact that investors receive higher payments should the issuer fall short of sustainability targets, and investor concern about the latitude allowed to issuers in setting those targets.
Potential responses suggested by Fitch include measures to improve comparability across issues, differentiated step ups and a larger role in the structuring of issues for independent advisors.
Failure penalties for issuers
SLBs have grown up in the wake of green bonds and other ‘use of proceeds’ debt instruments such as social and sustainability bonds. In contrast to green bonds, the use of whose funds is restricted to identifiable projects, there are no constraints on the use of SLB-raised capital.
Noted Fitch: “This flexible structure has allowed for more companies across different sectors to gain access to sustainable financing, particularly those that are not able to allocate large amounts of funding to dedicated green or social assets.”
By the middle of 2022, cumulative SLB issuance had reached US$147 billion, and in the second half of 2021, SLB issuance outpaced that of social bonds.
At the heart of the SLB framework is the setting by the issuer of sustainability performance targets and its selection of key performance indicators (KPIs) to measure the extent to which it has or has not met these targets.
Failure to reach set targets will result in a penalty for the issuer, usually in the form of the ‘coupon step-up’.
This describes the obligation on the issuer to pay a premium on top of the coupon already due on the bond in question. But according to Fitch, this brings two problems.
The first is that the majority of SLBs, despite their many differences, pay a step-up penalty of about 0.25%. Fitch says: “Our analysis finds almost no correlation between an issuer’s credit rating and the coupon step-up. There is also no indication that step-ups are structured based on the ambition of the targets or on the cost required to achieve them.”
“Lack of clear guidance”
It added: “Step-up rates should be further differentiated to account for variations in the financial operational and sustainability profiles of issuers, and improve transparency for investors.”
The second problem, said Fitch, relates to the moral hazard inherent in the fact that investors would seem to have a stake in issuing companies failing to meet their targets.
Seasoned observers of the SLB scene reply that investors in such bonds want them to succeed, not to fail, otherwise they would be invested elsewhere.
Elsewhere, said Fitch, the very flexibility in setting targets that has appeal for issuers is putting off some investors. “Asset manager Nuveen disclosed in 2021 that it had passed on investing in SLBs from a US high-yield issuer and an Indian cement company because it felt the structure allowed the issuers too much ‘latitude’ to invest proceeds, and penalties did not provide enough incentive to significantly improve their carbon footprint.
“The lack of clear guidance on the suitability of performance targets at the product’s launch creates a knowledge vacuum for both issuers and investors.”
The first SLB is generally considered to have been issued by Italy’s ENEL in September 2019 and most follow the Sustainability-linked Bond Principles established by the International Capital Markets Association in June 2020.
In June, the ICMA published a registry of 300 KPIs for SLBs alongside resources and guidance, partly driven by a rapid take-up by issuers looking to finance efforts to reduce their CO2 emissions.
Conflict of interest
Energy and utilities make up the largest single category, 28% of the total, of SLB issuance. For these issuers, KPIs are typically clear and easily verified, as they mainly relate to the measurement of reductions in greenhouse gas emissions, in contrast to other possible performance targets.
Fitch notes that the assessment date to see how an issuer has progressed towards its performance targets can be set close to the maturity dates of the bond, “which means step-ups are paid on few coupon payments”.
It added: “Bringing assessment forward, closer to the midpoint of the bond’s tenor, would increase the penalty’s impact.”
One of the report’s authors, Melissa Cheok, Associate Director, ESG Research at Sustainable Fitch, described the market as largely self-regulating, with issuers setting their own penalties. She said a “herd mentality” had led to the average step-up of 25 basis points, which could potentially represent quite a lot of money for an issuer of high-yield bonds but a relatively small sum for issuers of investment grade bonds.
She said: “It may be counter-productive to rely on the same bankers and advisors who benefit from these transactions to help issuers design the frameworks and step-up penalties for SLBs.
“Something that can be done to ensure the integrity of these products is to get independent advisors and reviewers involved much earlier than the current external review period to perhaps help advise on materiality, alignment with science-based targets, conducting context-specific assessments and metrics to measure success.”
Cheok added: “Also, issuers could explore setting the same base year for their sustainability performance targets and KPIs to ensure better comparability across similar offerings. This would make it more challenging for issuers to cherry pick the metrics they use to measure success for their set targets and provide more transparency to investors.”