In defence of SLBs
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In defence of SLBs

Critics of sustainability-linked bonds are missing the point, badly

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Sustainability-linked bonds are catching a lot of shade at the moment. The on trend chat in sustainable finance circles is that they have lost the glow they enjoyed in 2021, when the product was sweeping all before it in corporate finance.

Back then the rate of adoption was astonishing. Among European companies, after two years with just €4bn of annual issuance, it soared to €44bn. Despite the newness of the product, the whole market seemed to be behind it. Dozens of institutions wanted to get in on drafting the Sustainability-Linked Bond Principles, published in June 2020.

At the time it did not seem outlandish to predict that SLBs would eclipse corporate green bonds, or even that they would one day come to replace normal bonds. After all, Enel, the original issuer, has made — and stuck to — a promise that it will only issue senior bonds as SLBs.

But this year, the mood has changed. Market participants have told GlobalCapital that investors have lost interest in the product; that, unlike green bonds, it brings the issuer no pricing benefit; and that issuers are going off it, disenchanted by the lack of warmth from investors.

Poking holes

Underlying the decay of SLBs’ glamour are several criticisms of the market. Commentators argue that the sustainability targets to which companies tie their bonds, agreeing to pay step-up coupons if they fail to hit them, are in many cases not stretching. There is not much chance that issuers will miss them, so the targets are not ambitious and hence worth little.

For some, this affects their financial view of the structures. If there is a low probability of the step-up being paid, that diminishes the option value in the deal and hence its overall valuation. Even if the targets are not dismissed as weak, investors complain that they find it difficult and time-consuming to form a view on this issue. It’s a brain-ache they can do without, so when an SLB comes to market, sometimes investors just ignore that aspect and think of it as a normal bond.

The coupon step-ups themselves are criticised: too small or too late in the deal’s life to be financially motivating to the issuer, or too easy to sidestep by calling the bond or changing the measurement criteria.

These flaws put companies that issue SLBs at risk of being accused of greenwashing — something nobody wants, and which is even starting to acquire a taint of illegality, as regulators are exploring measures to clamp down on it.

On top of that, bankers say SLBs rarely price or trade tighter than issuers’ normal debt, unlike green bonds, which, in the right market conditions, are still bookbuilding box office.

Enel continues to support SLBs loyally, but outside observers are sceptical that its original hope has been met: that a substantial spread benefit would flow from the product, as it unlocked investors’ appreciation of Enel’s true virtue as a sustainable company, which was not being priced in with ordinary or green bonds.

Compared with this fiddly and baffling product, many investors continue to prefer green bonds, which confer the cheerful, satisfying feeling that ‘my money is going to green investments’.

No obituary

So far, it is much too early to write off SLBs. Some investors remain enthusiastic, and as GlobalCapital’s analysis last week of the 50 biggest issuers in Europe showed, only five can yet be considered to have clearly turned their backs on an opportunity to issue SLBs by reverting to issuing conventional or green bonds. And even that turning away may be only temporary: the issuers might return to SLBs.

However, sustainability-linked finance has clearly lost much of the enthusiasm and momentum that drove it two years ago. This may be, at root, no more than an unintended consequence of European Union regulation. The Sustainable Finance Disclosure Regulation compels most asset managers to disclose how they fulfil sustainable investment objectives. If green bonds tick boxes on SFDR filings and SLBs do not, sustainable investors will tend to prefer the former.

But to ignore SLBs or let them dwindle into obscurity would be a grave mistake.

As GlobalCapital has long argued, there is nothing wrong with green, social or sustainable use of proceeds bonds in themselves. At the margin, stimulating demand — as the green bond movement has done impressively over the past 10 years — can create incentives for companies or governments to engage in green investments. But, unless other regulatory levers are applied, the stimulus is very faint. Organisations are not going to build new wind farms or buy more efficient machinery because they can finance it with a green bond.

These organisations still need to earn a return on the asset that can cover their cost of equity and debt capital. The minuscule greenium that might be gained on a green bond is far too small to be material to any investment decision taken months or, in the case of large projects, years before. It is a rounding error compared with the volatility of capital cost that arises from weekly fluctuations in market conditions. The only market where a bond’s greenium could be worth considering, compared with the underlying asset pricing, is green mortgages.

Fundamentally, with very few exceptions, green bond investors should not kid themselves that they have caused the creation of new green assets that were not going to be created anyway.

Claims that green bonds have ‘impact’ while other bonds do not are therefore misleading.

Whole, not part

A green bond labels the fact that the issuer has made some green expenditure. But it says nothing about the overall tendency of the issuer’s activity.

Conscientious green bond investors do consider the all-round ESG characteristics of issuers they buy. But the structure of the security itself does not bring this to the fore — in fact, it directs attention away from it. The whole premise is that the investor ‘finances’ only the green spending.

At a market-wide level, it could be argued that green bonds have distracted bond investors from the beam in their eye — all the environmentally and socially harmful things they finance.

Enter the SLB. This security can, and in many cases does, address the whole of the issuer’s activity. There are exceptions of course, where the targets refer to only part of the operations — for example, Enel’s bonds are linked to greening its power and heat generation, but not its gas supply business.

Nevertheless, in its basic conception the SLB describes the issuer as a whole organisation. It is also always tied to an improvement — exactly what sustainably minded investors should want.

Because SLBs concern improvement, not fixed assets, they are flexible and suitable for use by issuers in transition to better practices, socially or environmentally. This ought to be all organisations.

Sustainability-linked debt is harder to use for financial institutions, because their involvement with the world is at one remove, through financing other actors. Even they could technically issue sustainability-linked debt.

But across the vast majority of the corporate and government sectors, there is almost no organisation that cannot issue sustainability-linked debt.

There are many, on the other hand, that cannot issue green debt, because the green or social improvements they need to make do not cost enough to cover a bond issue. A media company, for example, could greatly improve gender and ethnic equality in its workforce and minimise its carbon emissions by buying renewable electricity and taking fewer flights. These measures would cost something, but not hundreds of millions.

Or take a high emitting, heavy industrial company. Would you rather know that Cement Inc has spent $1bn on greener kilns or that it has reduced its emissions by 5%? The latter may not sound much, but the former tells you nothing at all about its environmental impact.

Wrong end of the stick

Complaints that SLB targets are too soft, or that the coupon step-ups are not big enough to change corporate behaviour are missing the point entirely.

SLBs are not levers which companies hand to investors saying: “Go on, use this to make me greener. I’m not sure I’m going to bother otherwise.”

The sustainability targets have already been set by the CEO and the board. No one should expect companies to miss them very often, since companies do not generally announce targets they intend to miss.

By issuing an SLB, a company is saying: “Look at my targets. I think they’re important, and you should too. And I’ll give you a few cents if I miss them.”

The coupon step-up is a freebie given to the investors — just like the freebie that comes with green bonds: feeling that your money has gone to a green purpose. To all who know that money is fungible, that benefit is arguably imaginary.

With an SLB, the benefit may not seem much, but it is real: if the issuer misses its target, you will get a small compensation payment. This must be better than not having the compensation.

It’s similar to the coupon step-ups that some investment grade companies used to attach to their bonds that would be triggered if they were taken over and downgraded to junk. No one invested in these bonds in the hope that they would be junked — nor did anyone think the step-up could prevent a private equity firm buying the company. But it was a compensation that did investors no harm, and might benefit them.

Critics say “a 25bp step-up isn’t enough to motivate management”. Perhaps not — but, even more surely, neither will no step-up.

For investors, SLBs are inherently superior to ordinary bonds. For investors that take a holistic view of the issuer’s ESG characteristics and consider that money is fungible, SLBs are also superior to green bonds.

And as for complaints that the targets are too easy, these gripes are a feature, not a bug.

By issuing an SLB, the issuer thrusts its sustainability plans under the investors’ noses. Shock, horror — some of them are not that ambitious!

With an SLB, the investor can’t help noticing it. But what about the sustainability targets of all the issuers of the 85% of European corporate bonds sold last year that were not sustainability-linked?

No doubt the pious investors who criticise the SLBs have checked all those and found that they are impeccably relevant, material and ambitious?

The right questions

The best thing that can happen to SLBs is for investors to sit down and calmly think about what they are. They are ordinary bonds with a free extra compensation payment for the investor if a sustainability target is missed. No more, no less.

An SLB is not a mechanism to make a company sustainable — it’s just a bond, for goodness' sake. A bond with an extra, almost token, smidgeon of insurance on the side.

So there is literally nothing to object to, and only benefit for the investor.

Having realised that, the next step is for investors to demand the bonds from issuers.

At every bond issuer’s roadshow, investors should be asking: why are you not issuing an SLB? Are you not confident about hitting your sustainability targets? What if you miss your targets — how are you going to compensate us?

Creating this demand could generate a small greenium, as has happened with green bonds. Investors may not like that, but they should not be put off by it. It will encourage issuers to issue more of them.

The potential supply of SLBs is not capped, as green bonds are. Once companies convert to issuing all their bonds as SLBs, their bond curves will just be their bond curves. Companies that offer SLBs may trade tighter than others, or they may not. It doesn’t matter much: that is not the point.

The SLBs will have got investors — and therefore companies — talking and thinking and caring about their core sustainability targets, whether they are going to be achieved and whether they are ambitious.

What is sustainable investing if not that?

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