Public sector borrowers from Asia, Latin America and Europe should intensify efforts to issue sustainability-linked bonds – and not worry about occasionally missing performance targets. That was a principal message from the OMFIF Public sector debt summit. Failing to meet these targets has implications for issuers’ reputation and credibility, particularly for sovereign, supranational and agency borrowers given their status as leaders and standard-setters in the bond markets. However, this should be welcomed as a sign of issuers setting ambitious targets – not as a shortcoming.
SLBs have penalties embedded into them for missed targets, but the penalty is a secondary concern for issuers entering this market. ‘It’s a bit of a risk to do the SLB because you put yourself out there by setting these targets that, if you fail, there’s a political backlash,’ a fund manager at a leading asset management firm said at the summit. ‘It’s very visible that you haven’t achieved your targets.’
Trading off tougher targets with purposeful issuance
Missing SLB targets should not invite political backlash. The product is designed to encourage issuers to be ambitious. If issuers occasionally do miss their targets, they can strive to meet them in the future.
‘How do we square that to make sure we are seeing people making ambitious KPIs, but where they are missed, and missed narrowly, that somehow this actually reinforces the credibility of the market rather than the opposite?’ asked a senior funding official at a European SSA borrower. ‘I think it’s a great deterrent for issuers when they see that kind of backlash.’
Investors have been calling for more ambition in environmental, social and governance frameworks. They should welcome tougher KPIs and accept that issuers will occasionally miss these targets. It should not lead to a mass sell-off of the issuer’s bonds or a loss of credibility for the issuer.
‘I actually think it’s a very healthy situation to have misses in the market,’ said a head of ESG fixed income at another leading asset management firm. ‘If you look at the situation we had a couple of weeks ago with that PPC corporate issue, they missed their targets and [investors] didn’t puke bonds. The reason was, quite clearly, that they had this external shock event, i.e. the war in Ukraine, which resulted in them having to keep a very carbon-heavy generation in their mix.’
Other issues affecting the adoption of SLBs by SSAs include the lack of consensus on the two-way pricing of SLBs, some investors’ scepticism on the financial penalties being sufficient to drive change as well as the focus on the more established use-of-proceeds framework for sustainable issuance by western European borrowers.
There is also the argument that, for developed market issuers, the step-ups need to be adjusted from what has been set by EM issuers due to the tighter spreads for high-quality credits. But public sector borrowers need to tread a fine line in the management of taxpayers’ money and driving change.
Will SLBs catch on?
Only two SSAs have issued SLBs to date – Chile and Uruguay, who sold these instruments last year – but more Latin American and emerging market sovereigns are expected to follow. So far, there are no concrete plans for any western European or developed market SSAs to follow, though some European SSAs are exploring the possibility. At least one French SSA is ‘toying’ with the idea, according to an investor at the OMFIF summit. ‘Whether they move forward with it, I can’t say as it’s ultimately up to their Treasury department.’
For now, the feeling is that the SSA SLB market will continue to grow, albeit slowly and with a focus on EM issuers. A senior funding official at an EM sovereign said they were looking at issuing SLBs given the flexibility of this product over a use-of-proceeds framework. He said the debt management office was looking for technical assistance with the potential issuance of a debut SLB later this year.
In a poll of the attendees at the OMFIF summit, 75% said SLBs will become mainstream products of SSA issuers in 10 years’ time. There is hope that the product will catch on within the wider SSA market – perhaps once the concerns about adoption are dealt with.
Burhan Khadbai is Head of Content of the Sovereign Debt Institute at OMFIF.