Who gains from bad performance?
One of the more interesting anomalies of sustainability-linked securities is that investors can benefit, in the form of margin step-ups, from a borrower’s poor sustainability performance. The market is still discussing the most appropriate response.
JENKINS I know investors that are already thinking this through in the context of sustainability-linked bonds and how to manage this should it occur. Some European borrowers have already entered into SLLs where they have stated that if they were to get a coupon step-down they would want to reinvest it into other sustainability-linked measures.
We advocate that SLLs have both margin incentives and penalties to encourage ambitious and material environmental, social and governance (ESG) risk and sustainability improvements from borrowers. This should improve ESG risk and, in the longer term, credit risk.
CHEN It is a tricky issue but I still advocate for both a step-up and a step-down. At the moment, it is a bit of an incentive for the client but, down the track, SLLs should have KPIs that more explicitly affect the underlying credit profile of the borrower. If you follow this logic through, you need the step-up and step-down.
Philosophically, I have no issues with investors accepting a higher margin if ESG performance drops, because this reflects underlying credit performance. But optically, there are challenges to this, so I like the idea of reinvesting incremental returns.
When we talk to clients, we are always pitching to have both step-up and step-down provisions. This is how you get credibility, as both parties have skin in the game. For ESG-linked bonds, there is nothing that stops the structure of a step-up and step-down being used, it is just whether investors are willing to take a step-down.
DEAN It shouldn’t be too easy for issuers. Sometimes issuers say it is too complicated, but the structure needs to hold them to account. It can be tailored, but for issuers to get the credit, the product needs to have credible targets.
This is our approach, instead of having a target of lending a certain volume of SLLs by a certain date. We are not in the business of growing this product just for the sake of it. Similarly, I have no interest in doing a deal with a borrower that just wants the discount.
We advocate that SLLs have both margin incentives and penalties to encourage ambitious and material environmental, social and governance (ESG) risk and sustainability improvements from borrowers. This should improve ESG risk and, in the longer term, credit risk.
CHEN It is still important, not least because we would question deals with borrowers that are just in it for a discount. I think it also helps with market development.
There is an example with the green-bond market. It boomed initially, and then there were many questions around greenwashing. Now we have definitions and standards in place to help with legitimacy.
It will likely be the same with SLLs. We may be in a honeymoon period at the moment. But if deals are structured just for cheap financing and the targets aren’t based on material issues or aren’t incremental, it could impede the development of the market.
