Uruguay’s step-down SLB will call investors’ bluff
If ESG drives credit risk, the structure has logic
Capital markets issuers are often applauded as bold, but few have deserved the term as much as Uruguay. It is preparing to issue a genuinely innovative transaction, which will demand something of investors that they may be unwilling to give.
So far, all public sustainability-linked bonds have granted investors a one way option: if the issuer fails to hit a sustainability target, they get a compensatory step-up in coupon. What’s not to like?
For the first time, Uruguay is going to say: ‘OK, you can have that protection. But if we absolutely smash our sustainability performance, you pay us an equal amount.’
Some would say: ‘Fair’s fair.’
The widespread acceptance of SLBs suggests that many agree a disappointing environmental, social and governance performance by an issuer points to weaker credit quality, other things being equal.
An SLB step-up offsets any bond price fall the investor might suffer.
If investors really believe this logic, they ought to accept the opposite: ESG outperformance implies stronger credit, which could deserve a coupon step-down.
Another rationale for responsible investing is impact. Investors say they want to make a difference in the world. If so, they should be willing to give issuers a small incentive for truly impressive sustainability achievements.
Uruguay’s deal will put investors on the spot. Do they really mean what they say about ESG, or is it just for the marketing brochures?
As usual, hand-wringing about fiduciary duty will get in the way. Buying an SLB with a step-down creates a risk that clients might lose some return.
The objection is nonsense. Asset managers take risks all the time — currency, interest rate, credit and many other risks. Is there some special reason why the ‘risk’ of a great sustainability outcome is more perilous to clients?
We do not know yet whether Uruguay’s deal will fly — or, if it sells well, what the implications will be for future debt markets.
Investors might buy the bond, but undermine the attraction for Uruguay by demanding extra spread up front. The incentive would still be there just as strongly for it to achieve the step-down, but success might not feel like a bonus, since it was so grudgingly given. Other issuers might then be less willing to follow suit.
That would be disappointing to believers in the product. The big prize they hope for is binding governments to long-term targets, giving them some resilience to electoral buffeting.
One thing we can say for sure. If such two-way SLBs do take off among sovereign borrowers, they will achieve one important advance: they will carve into the edifice of the sovereign debt market the message that sustainability issues are relevant to government credit risk.
For that alone, Uruguay’s pluck deserves to be rewarded.