Developed market sovereigns not ready for SLBs yet

Emerging markets will continue to lead the way

Sustainability-linked bonds will not be adopted by developed market sovereigns any time soon, with these issuers remaining focused on traditional use-of-proceeds bonds rather than those linked to key performance indicators.

Speaking at the launch event of the Public Sector Debt Outlook 2023 report by OMFIF’s Sovereign Debt Institute on 26 January, Gregory Smith, an emerging markets fund manager at M&G Investment, said there is ‘a big, stark difference’ between emerging and developed market sovereign issuance of SLBs.

There have only been two sovereign SLBs issued – from Chile and Uruguay – and there is no sign of any developed market sovereigns bringing SLBs in the near future. In a survey of public sector borrowers as part of the Public Sector Debt Outlook 2023 report, only three sovereigns said they would issue SLBs this year and those were all from emerging markets. Meanwhile, only two of the 13 panellists at the event said they expected to see big, developed market issuers bringing SLBs within three years.

Patrick Barbe, head of European investment-grade fixed income at Neuberger Berman, said developed market sovereigns were more focused on project-based bonds rather than KPI-linked bonds. He added that the step-ups may need to be ‘fine-tuned’ to be more attractive to investors, particularly given that developed-market sovereigns have tighter spreads than those in emerging markets.

Following last year’s SLBs from Chile and Uruguay, emerging market sovereigns will continue to lead the way for sovereign SLBs. Brazil could be a potential candidate for an SLB. Luis Felipe Vital, head of public debt operations at Brazil’s National Treasury, said the sovereign is looking to bring a debut environmental, social and governance-related transaction but declined to comment on whether it would be in SLB format.

‘During last year I saw some of my peers like Uruguay, Chile and Mexico and they had very interesting ESG-related transactions in the external market. That’s something I congratulate them on and Brazil is looking forward to being in same place in the near future,’ said Vital.

He added Brazil has been working on developing an ESG framework with the World Bank and the Inter-American Development Bank, with plans to bring the deal in the external market in 2023 after being absent from the external market in 2022 due to volatility.

‘On the SLB side actually it’s not just about finding cheap funding,’ said Jana Harvey, senior portfolio manager, emerging markets, at BlueBay Asset Management. ‘SLB instruments have a very crucial function to ensure that sovereigns and investors are serving their commitments on the environmental side.’

Another issue affecting the development of the SLB market is that there is no consensus on the two-way pricing feature of SLBs, which was introduced by Uruguay with its debut deal last year. According to the survey of borrowers as part of the Public Sector Debt Outlook 2023 report, three-quarters of respondents were unsure on this being a good idea.

In addition to SLBs, the increasing use of ESG ratings is also a hot topic, with two-thirds of borrowers surveyed saying that ESG ratings are becoming more embedded in their investor relations. This is particularly the case for emerging market public sector borrowers where the figure is almost 80%.

‘I think we’re all moving in the right direction,’ said Smith, on the increasing use of ESG ratings by sovereigns. ‘I guess the thinking around ESG has been much better developed for corporates and it’s now picking up with sovereigns and you’re seeing that in the ratings and research. But we’ve still got a way to go… the mainstream rating agencies are certainly integrating ESG risks in their ratings which is a real positive.’

However, there are issues with ESG ratings. ‘I find ESG ratings are not as uniform in what they’re looking at as credit ratings and that creates an automatic problem,’ said Isabelle Laurent, deputy treasurer and head of funding at the European Bank for Reconstruction and Development. ‘So, is it looking at the effect of, say, the environment or social impact on a firm or is it looking at the firm’s impact on the environment and on social issues? People are rating very different things and looking at it from very different perspectives.’

Burhan Khadbai is Head of Content at OMFIF’s Sovereign Debt Institute.

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