The role of transition bonds

Corporate balance sheets are more suited to funding based on sustainability scoring than the use-of-proceeds approach taken by green, social and sustainability (GSS) bonds. In theory, there is no reason why financing supported by the principles of sustainability-linked loans (SLLs) could not also be available in bond format.

ZAUNMAYR Could SLL principles be applied to the bond market, perhaps as the basis for the issuance of transition bonds?

TAPLEY It has now happened offshore, with a transaction by ENEL. This is an Italian energy distributor with operations across Europe. It issued a bond referencing its emissions-reduction target. If this is not met by 2021, the coupon the company pays to investors steps up by 25 basis points.

ENEL has not been able to get investors to agree on a coupon step down. But I think this will come in time. It is no different from the risk-rating pricing grid we sometimes see in bond transactions.

BYRNE Was any discount provided on issuance?

CHAPPELL It is always hard to compare in this circumstance but the primary-market bond pricing was most likely inside where ENEL’s vanilla bonds would have priced that day.

TAPLEY This is much like what we see in bond markets for use-of-proceeds deals. They tend to price at the lower end of indicative ranges if not tighter. There is liquidity tightening in these transactions because of the demand.

I would love to hear from Marayka Ward and Graham McNamara on how comfortable they would be with a coupon reducing when a customer produces the results to enable it.

This is an aspect of the structure we have been speaking about with investors for the possibility of it being implemented in the bond market. It is definitely a sticking point for investors. It is harder to corral a group of 60 or 70 investors in a transaction than it is to do so with a bank syndicate. But the ENEL deal is a good first step for the bond market.

WARD We haven’t been in loans for a long time but we are standing ready and wanting to see one of these sustainability-linked bonds in the market. Administratively, we would see it no differently from a coupon step-up or step-down on a rating downgrade. We have a few of these in our portfolios, particularly in the transmission-distribution space in electricity bonds.

We don’t think there is a problem to process this through our settlement systems. What we would need to see is some transparency on the provision of pricing. We have board limits on how much of our assets can be marked to model so we would need a pricing provider on such a bond.

But, assuming it goes through Austraclear and is a benchmark public bond, we would not have any problem with it. It would be a definitive step towards supporting transition stories.

MCNAMARA Our funds are all invested in loans and – while we do not have any specific environmental, social and governance (ESG) targets or a specific sustainability fund – we are happy to look at almost any transaction and assess it on its merits. We have no fundamental problem with step-up or step-down structures as long as the risk-return metrics are acceptable.

TAPLEY One aspect we need to be cognisant of is the ethical and moral dilemma around a windfall. If a borrower fails to do what it has set out to do, and there could be multiple reasons for this, there is a windfall to banks and other investors. In Europe, we have seen banks donating this windfall to charity when they get it. This piece needs more development and thought, though.

WARD This windfall dilemma is difficult because at the end of the day it is not our money, it is our clients’ money. We do not have a sustainable fund or a specific ESG mandate. When we buy GSS bonds they go into a pooled portfolio that might have multiple investors. So there would be an administrative issue dealing with a windfall gain from a coupon step up that results from an issuer’s failure to achieve targets.

No investor is complaining to us about dedicating resources to the space, so I think it would be a fairly easy conversation. But at the end of the day we are the custodian of the money not the owner of the money.