To say that sustainability-linked bonds have not taken off among sovereign issuers would be putting it lightly, with only Chile and Uruguay having sold deals in this format. That is set to change, with a sovereign in Europe expected to bring a debut trade in 2025, in what could spark a wave of SLBs in the continent.
The development of SLBs and sustainable finance were discussed in detail at the Global sovereign debt forum, hosted by OMFIF’s Sovereign Debt Institute in June. The flagship event brought together prominent asset managers, debt management offices and other emerging market participants for a series of high-level discussions.
Speaking at the forum, a head of a European DMO said that while the sovereign continues to issue classic sustainable products, ‘this is not enough’. As a result, they are preparing an SLB framework of which they are in the ‘final stage of articulating the KPIs’ with plans to issue a debut SLB in 2025.
Two-way pricing dilemma
However, the DMO faces a challenge in agreeing on a two-way pricing approach for its SLB with investors. This is so that the SLB does not just serve as a penalty for the issuer if it misses its targets with a step-up in the coupon, but also that it gets rewarded with a step-down in the coupon if it exceeds its targets.
Uruguay sold the first SLB with a two-way pricing feature with its debut transaction in 2022, but it was not an easy sell to investors. ‘We were quite sceptical on whether this would fly,’ said a senior portfolio manager in emerging market debt, adding that as a ‘prudent investor’, it is difficult to assess the value of an SLB in a portfolio when it has the risk of a coupon step-up.
‘It is essentially a digital option on future cash flow,’ said a market participant at the forum. As an investor, ‘you have to think about what is the probability that this option is going to pay up’, he added, which determines how much an investor would be willing to put into the bond. It is a form of a hedge.
In June 2024, Enel, the Italian energy company, came a few basis points inside its curve after missing some of its key performance indicators on an SLB. This shows the benefit of SLBs for issuers: you can sell them with a premium to investors if you have ambitious targets which might not be met. Investors pay up to buy the bond in this sense but then are likely to be compensated by a coupon step-up.
On the other hand, if an issuer exceeds its targets and the coupon is lowered, it should not be seen as a penalty. Investors should be willing to accept a lower coupon as part of their mandates to promote impact as well as support the sustainable transition.
Backlash for missing targets
In addition to a financial penalty, issuers are also worried about a political and reputational backlash to missing targets.
‘It feels like you’re setting up for failure and there’s going to be a stigma if you’ve failed on your targets,’ said a market participant at the forum. However, he recalled Enel’s case of missing a target on one of its SLBs, facing a step-up on its coupon and seeing their bonds rally.
‘They got financial compensation for failure of the target, but they were able to access the market immediately afterwards while retaining their credibility,’ said the market participant.
In other words, it is not a big deal if an issuer misses its targets. It should instead be viewed positively if an issuer occasionally misses its targets as SLBs are designed to encourage issuers to be ambitious with their sustainability goals.
Sovereigns should not be deterred but rather encouraged to issue SLBs. These products are poised to move the labelled bond market forward in promoting ambitious transition plans. Could more sovereigns come to the market? That is the hope. Costa Rica is looking to bring SLB issuance in its domestic market as part of its plans to sell labelled debt. Meanwhile, South Africa is understood to be preparing an SLB framework. Many others will be looking at it closely.
For more on the growth of the SLB market, listen to OMFIF’s recent podcast with Ulf Erlandsson, founder and chief executive officer of the Anthropocene Fixed Income Institute.
OMFIF will be continuing the discussion on SLBs at the European sovereign, supranational and agency forum on 19 September. Click here to find out more and book your place.
Burhan Khadbai is Head of Content, Sovereign Debt Institute at OMFIF.
