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SLBs and escaping secular stagnation

Biden_PA_575x375_5February2021

This week in Keeping Tabs: do investors want companies to fail on sustainability-linked bond targets? And what what happens to the economy under a Joe Biden presidency in the US?

Sustainability-linked bonds are one of the big new crazes in ESG capital markets. For the uninitiated, issuers commit to targets related to sustainability, and the coupon steps up if they do not meet these goals.

On M&G's Bond Vigilantes blog, Charles de Quinsonas discusses what appears perhaps to be a paradox for investors: they burnish their sustainability criteria by buying the bonds, but in actual fact would gain financially if the issuer turns out not to be so virtuous. Is it natural to expect bondholders to want these companies to fail on green or social targets?

However, he points out: "To be part of the cynical — and rather bold — camp wishing an issuer not to meet its sustainability targets, one must make the assumption that credit risk is not (or is very little) influenced by the company’s key performance indicator (GHG emissions, water consumption, etc.) set in the sustainability-linked bond documentation."

Much of the drive for sustainable finance is based around the idea that a business scoring highly on ESG factors is a better business. This implies that failing to meet a material sustainability target would by its nature likely be damaging to an issuer's credit profile. At the same time, if demand for SLBs is based partly on their value as an ESG-compliant investment, failing to meet the agreed goals may turn off some investors and result in a fall in the price of the bond.

So, there should be a downside to the bondholder for an issuer failing to meet the targets. Therefore, one way to look at the coupon step-up is as a form of investor compensation for a company failing to meet its targets, de Quinsonas suggests.

Moving to the broader fixed income investment landscape, analysts at Algebris Investments reckon that the Biden-Harris administration in the is a potential "game-changer" amid risks to the recovery and of increased inequality. They say that the most important question for investors is whether the US can beat secular stagnation.

They are positive on the Biden stimulus plan, but reckon that "to push the US economy out of the Covid crisis and out of secular stagnation, what is needed is much more radical." The propose infrastructure investments, widening access to education and breaking up monopolies.

As for what all this means for investors, they say: "We do not know whether Biden’s reform agenda will win over secular stagnation — but we do know that a traditional bond or credit portfolio is poised to underperform either way."

They claim that prices of bonds can hardly rise much more. They are exposed to inflation in the event of a strong economy recovery, but also to spread widening if the economic pain continues.

So where is the opportunity? They point to the ability to pick winners and losers as individual issuers' bonds and different sectors remain dispersed. Cyclical sectors could benefit once economies re-open. They also recommend convertible debt due to the potential for equity upside.

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