So far in the young life of sustainability-linked bonds, there has only been a financial upside for investors. If a corporate or a sovereign fails to meet its key performance indicators, investors are rewarded with a ‘step-up’ in the coupon of the bond.
Now, investors are being introduced to a two-way pricing feature with not only a step-up but also a ‘step-down’ in the coupon if the issuer exceeds its KPIs. Uruguay has brought this innovation to the market through its SLB framework.
It hasn’t been an easy sell to investors. This was to be expected as there is a risk of a financial downside embedded into the transaction. However, is it really a penalty if an investor is supporting an issuer in exceeding its climate and nature targets?
It should not be seen as one. Investors should be willing to accept a lower coupon if an issuer exceeds these targets as part of promoting and advocating for the climate and sustainable transition. It is also only fair for a product to offer incentives to both parties. If an issuer has to pay a higher coupon for failing to meet their targets, it is right that they have their coupon lowered if they exceed those targets. By accepting a step-down coupon, investors would be walking the walk when it comes to sustainability. Yes, maximising returns is central to investors, but it shouldn’t be everything when it comes to impact investing.
It is important to note that, with Uruguay’s SLB framework, the sovereign has to not just meet but exceed their KPIs to receive a step-down in the coupon. For the first KPI, which is linked to the reduction in aggregate gross greenhouse gas emissions per real gross domestic product unit by 2025, Uruguay must reduce by more than 52% to receive a lower coupon. If there is a reduction of 51% or 50%, there would be no change to the coupon. The same applies to the second KPI, which is linked to the maintenance of the country’s forest area by 2025 in that it must exceed the target.
Uruguay has not yet set what the reduction in its coupon will be, although the market standard for step-up coupons in SLBs is 12.5 basis points. The coupon step-up and step-down will be the same in terms of basis points and both of Uruguay’s KPIs will be weighted the same.
Some investors may also be uncomfortable with accepting a step-up in the coupon from a sovereign borrower. In addition to being seen as rooting for their failure, they will also be receiving a benefit funded by taxpayers. But with a two-way pricing feature, the risk is being shared by both the issuer and investor.
While SLBs have become popular in the corporate sector, they haven’t taken off yet with sovereign issuers. Uruguay will become just the second sovereign in the world to issue an SLB. Perhaps the two-way pricing approach will appeal to more sovereigns, with the feeling that climate and sustainability will be more integrated into the credit risk of issuers.
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.
Watch an interview with Herman Kamil, head of Uruguay’s sovereign debt management office, and Richard Sanders, director, sustainable and positive impact finance at Société Générale, here.