SLBs: fiddly but fundamental
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SLBs: fiddly but fundamental

Complex instrument panel from Alamy 1Dec22 575x375

Details of how SLBs will perform are cloudy, but their main effect is bright

The long honeymoon of sustainability-linked bond issuers and investors is coming to an end.

For three years, companies have issued the bonds in increasing numbers, offering investors step-up coupons if they miss sustainability targets.

Investors and bankers have busily debated how big step-ups should be, when they should occur during a bond’s life, and the central question of how to decide whether a target is robust and ambitious. The market has many champions, but many critics too.

Now, however, the real action is about to begin. Public Power Corp of Greece looks set to pay a 50bp step-up on a €775m bond — a much bigger market event than PKN Orlen’s small step-ups on two zloty notes this year.

Enel, the mother issuer, has targets coming up this New Year’s Eve and next that will be stretching.

Oddly for such a popular product, not even experts are really sure how they will behave when the very thing happens that is central to their design.

Even in a pure and fundamental sense, there is no consensus on what should be the market reaction.

Nor does anyone know what will happen in the rough and tumble of real trading. Will investors lap up the extra basis points or spit out the bonds in disgust?

The instrument is funky and still not well understood. Theories are traded about option value and whether the coupon change is material enough to compensate for altered credit risk.

But the bells and whistles may be beside the point. The main effect of SLBs is to direct the market’s attention to the issuer’s sustainability performance — especially, but not only, the specific metrics the deal targets.

Issuers hope to impress investors by backing their commitments with cash. If they look like missing targets, however, there is likely to be more scrutiny of that failure.

The bonds are likely to prove harder to handle in reality than on the issuer’s drawing board. Take PPC and Enel. Both have been plunged into a radically changed energy market this year. Governments in several countries have directly ordered power generators not to shut some coal stations as fast as they had planned.

A conventional ESG investor who looks at a company’s performance in the round could take all factors into account and conclude that this was not its fault and the holistic sustainability picture was what mattered.

But the SLB is a blunt instrument, tied usually to the reading of a single KPI at a single point in time. If PPC or Enel end up falling on the wrong side of that, despite their best efforts, it could be costly.

What matters more, however, is that the SLBs will have spurred the market to have the right conversation — about the issuer’s sustainability, whether the company is on track, how committed management is, whether it can realistically achieve its plans.

Many fixed income investors may ordinarily skate over these concerns, even though they are more at risk from them than SLB holders, who at least have the chance of some compensation.

Compared with the anodyne communication achieved by green bonds — look at my good work! — this is a step forward.

A few coupon step-ups are just what the SLB market needs to intensify the debate.

Public Power Corp’s bond was hailed as ground-breaking when it was issued in 2021, as a bold statement by a generator in a coal-dependent country. If it ends up stepping up, it may paradoxically have been even more valuable to the market.

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