One of the biggest obstacles to the growth and wider adoption of sustainability-linked bonds by sovereigns is the difficulty in assessing the true value of these products. This is because the coupons of SLBs are tied to issuers meeting specific targets on their sustainable transition plans.
However, structuring these bonds as ‘twin SLBs’ to assess the probability of issuers meeting their targets could be the solution. This involves issuing an SLB alongside a conventional bond with the same size, coupon and maturity. One would have a coupon with a step-up/step-down feature tied to key performance indicators while one would just have a standard fixed-rate coupon.
The idea is that this structure would enable the market to assess how likely an issuer is to meet its KPIs. For example, if the KPI-linked bond trades at a similar price to the conventional twin, it would suggest a high probability of the issuer meeting its targets due to a low expectation of receiving a coupon step-up. Conversely, if the SLB trades at a higher price than the conventional twin, this would imply that there is a high chance of the issuer not meeting its targets. In other words, there is more demand in the bond as investors are expecting to receive a coupon step-up.
‘It’s useful for investors,’ said Ulf Erlandsson, founder and chief executive of the Anthropocene Fixed Income Institute and one of the leading voices on the SLB market. ‘If you’re a big pension fund or asset owner with 20% to 30% of your capital tied to high-grade government bonds, you’ll be able to measure how your portfolio is aligning with net-zero climate targets.’
‘It’s also attractive to issuers themselves as they will get data on how credible their transition plans are and, if a government changes their policy, the market will respond by repricing the bonds,’ added Erlandsson.
The twin bond structure is not new. Erlandsson wrote a paper about the concept in 2020, a few months before Germany began using this approach to issue its green bonds. The experiment has since proven to successfully demonstrate the so-called ‘greenium’. In 2022, Denmark followed the twin green bond approach but, beyond these two sovereigns, the structure has not taken off. Critics point to the fact that if an investor has an option between two identical bonds with the same credit and duration risk, there is no financial incentive to buy the green-labelled security if it is more expensive.
However, in the case of twin SLBs, there is a financial incentive to buy the KPI-linked bond even if it is more expensive than the conventional twin – particularly if there is a high probability of the issuer not meeting its targets as this would result in a coupon step-up. Moreover, the greenium that comes with the issuance of twin green bonds is based more on speculation on where a green bond should trade relative to a conventional bond. But with twin SLBs, investors are basing their assessment on data and the credibility of transition plans. It is much more robust.
By implementing this structure for SLBs, issuers would also be drawing in not just green and sustainable investors, but pretty much any investor that wants to seek a financial reward. With more investors, this will encourage more issuers to sell SLBs and from there grow the market exponentially. Moving to a market-based approach for assessing the probability of issuers meeting their targets for SLBs seems like a natural progression for this product.
While only Chile and Uruguay have issued SLBs from the public sector market, more sovereigns are actively looking at this product including those from Europe, Africa and Latin America. ‘In many ways, the sovereign, supranational and agency segment could be a more natural home for SLB issuance compared to corporates,’ said Erlandsson. ‘Robust SLBs require standardised and sophisticated datasets, and such datasets are generally produced by sovereigns and public sector borrowers already.’
Burhan Khadbai is Head of Content, Sovereign Debt Institute, OMFIF.
