Only investors, not issuers, can save sustainability-linked bonds

This year will be a watershed for sustainability-linked bonds: they will either gain strength as a product and gather more followers, or drift into a market backwater.

The first large step-up coupon event has occurred. Enel, the Italian power and gas company that invented the product, will pay 25bp extra on the coupons of €10.2bn of bonds, costing it €25m a year, in some cases for up to four years.

Enel has another €19.3bn of SLBs outstanding and has told GlobalCapital it will issue more, though it has not quite reaffirmed its former pledge to structure all its senior bonds as SLBs in future.

Had Enel not paid the step-up, it would likely have been fatal for the product, undermining investors’ trust. That it will pay means SLBs have unequivocally passed their first big test.

Allegations that the SLB is a doomed or dead product are wrong. They have some keen fans, both issuers that have used them repeatedly, and some big investors like Axa Investment Managers, Federated Hermes, Pimco and Amundi.

But there is no getting away from the fact that the product has lost the enthusiastic momentum of issuance it once enjoyed. Sales declined in both 2022 and 2023, and look likely to fall again this year.

Believers in SLBs make a variety of arguments for them. GlobalCapital has argued since the first deal in 2019 that SLBs have a great advantage over green bonds, in that they can address the complete operations of an organisation, rather than just a part of its assets or activity that is green.

We have also made the case that SLBs are, for investors, superior to ordinary bonds. Their credit risk is identical, but investors get an extra pick-up if something goes wrong with the company’s sustainability plans. What’s not to like?

Some SLB promoters go further, arguing that they are a lever with which bond investors can push sustainability forward. Issuers are incentivised to meet ambitious targets, stretching them towards a greener future.

But as GlobalCapital argued last year, that argument is unrealistic. Issuers’ decisions about going greener are strategic management choices, based on technological, competitive and regulatory factors. The costs are substantial.

Bond market participants greatly overestimate the market's influence if they think the ability to issue an SLB, or the risk of having to pay a coupon step-up, is even close to determining whether an issuer decides to replace polluting technology with clean.

Some of the most serious and astute supporters of SLBs make another call for how the market should be invigorated.

Its weakness, they argue, is not any fundamental aspect of the product’s design ― but that they have been used half-heartedly.

In essence, they argue that the coupon step-ups ― often 25bp ― are too small to matter to the borrower or investors. Simultaneously, the sustainability targets to which they are tied are often unambitious and unlikely to be missed.

The result is that the step-up is both small and unlikely to occur ― meaning investors place little value on them. Therefore, they will not pay up for them in the primary market, compared to the issuer’s ordinary bonds.

In turn, issuers are not motivated to issue a bond that may cost them extra coupon in the future, in return for no financial benefit up front.

The Anthropocene Fixed Income Institute, the think tank which is one of SLBs' most forthright champions, likens the product to an option and has a model for pricing and analysing them based on the Black-Scholes method.

The most obvious kind of option to which the step-up coupon in an SLB could be compared is an equity put option — the right to sell shares at a prearranged price, known as the strike. A put can be used to hedge an investor’s long position in a stock, since it will be in the money if the share price falls below the strike.

Like put options, SLBs hedge a potential bad outcome. If the issuer veers from its published sustainability plan, it is likely that things are not going well at the organisation, which, other things being equal, could well mean its bonds fall in price.

Triggering a coupon step-up would make the bonds more valuable, or at least arrest some of the decline.

But SLBs are not quite like puts, because the step-up payout is fixed, while the damage to the bonds’ price is unpredictable. By contrast, a put creates a perfect hedge, exactly calibrated to match any loss below the strike price.

Because of this, the AFII considers binary options instead of classic puts. In a binary option, there is a straightforward pair of outcomes: either a fixed payment is triggered, or it is not.

The next problem with the option analogy is that pricing options requires a wealth of historical information about the volatility of the underlying instrument, from which can be deduced probabilities about how likely they are to hit the strike prices.

This is completely absent with sustainability information. Companies are moving into new industrial territory, often introducing new technology. The future will not be like the past, and there is not even much relevant past data to extrapolate into the future.

The AFII believes a market in estimating sustainability probabilities could begin to emerge, and it is trying to stimulate that. It thinks the best place to start is with governments’ published decarbonisation targets.

One can look at the trend they have achieved in the past, and at the volatility of emissions indicators around the trend, and put those into an option pricing model to give a probability for a given forward strike price.

This analysis opens up a range of possibilities. Where SLBs exist, investors can work out whether they are likely to miss their targets, and decide to buy bonds which they think could be due for a payout, but are mispriced in the market.

Such a strategy would certainly have paid off for investors in Enel’s bonds, as in October those that later stepped up were trading indistinguishably from the company’s other bonds, and indeed sometimes cheaper. Since then they have outperformed.

Investors can also use SLB ‘option’ pricing as a stick to poke issuers such as governments. An investor could challenge a government to issue an SLB if it thinks its current policies indicate it is unlikely to hit its published sustainability targets. If the governments declines, says the AFII, it suggests it doesn't believe in its targets.

Above all, the point of such analysis is that if issuers brought SLBs to market with real, juicy 'optionality' ― substantial step-ups and demanding targets ― the investors would value it, and pay for it through lower spreads.

This would give the issuer a funding cost benefit, as long as it then went on to hit its sustainability target ― a valuable incentive for going green.

There is another difference from equity options to consider. With options, generally, a company can be assumed always to be striving to raise its share price. But it is not involved in the market for options on its stock. Both parties trading the option have no ability to influence the outcome.

An exception is a convertible bond, where the company sells an option to investors. But there the company and the investors want the same thing ― for the share price to rise and the embedded call option to be triggered.

In an SLB, the company is also a party to the ‘option’ trade, but it is anxious to avoid triggering a coupon step-up.

An investor trying to build a strategy around buying SLBs, and pricing those probabilities, in the hope of winning step-ups, will need to take into account that it is betting against the house.

The larger problem with this options-based analysis, and with the argument that issuers just need to offer more ‘optionality’ for SLBs to thrive, is that it seems remote from the psychological reality of the bond market.

For a market to develop in which investors bet on SLB step-ups, vying to estimate the probabilities better than each other, a critical mass of funds would have to be engaged in such activity.

At the moment, the kind of investors that want to do sustainable investing are motivated by a wish to do good, or at least to invest sustainably.

Such investors seem unlikely to want to engage in a cold, calculating, hedge fund-like strategy based on profiting when issuers miss their sustainability targets.

On the issuer side, too, treasurers are sincerely motivated to try and align their financing with the organisation’s sustainability targets. But are they so gung-ho and confident that they will stake big bucks on it by offering large step-ups?

If a company misses a sustainability target, the industrial and strategy officers will have questions to answer. But does the CFO also want to be in the firing line, and with a specific sum of money to shell out? That could be rather uncomfortable and will deprive the issuer of money to spend on sustainability.

Ulf Erlandsson, CEO of the AFII, thinks the market needs that cold, calculating, hedge fund mindset, more than the approach of investors who buy green bonds.

“They would rather buy something that is use of proceeds and have it fail," says Erlandsson. "We think that paradigm should change. There needs to be a tribe that starts doing it, and we are trying to professionalise it.”

For now, however, this brave new world seems a way off. If SLBs are to survive this year, it must be in the real conditions of 2024, not a utopia.

The way of thinking about them that could inspire confidence in the product is not to exaggerate the benefits or powers of an SLB, or to ask for them to be issued with more extreme terms, but to see them as a simple, fairly safe instrument. It carries only upside for the investor, and potential advantages for the issuer.

The company will set its sustainability targets according to industrial considerations. But by issuing an SLB, instead of an ordinary bond, it does two things. It offers investors a compensation payment, should it fail. And it highlights its sustainability targets, slapping them emphatically on the table for discussion.

As GlobalCapital has argued before, one of the main purposes of sustainable finance is communication, and SLBs are a prime example of that — they get people talking about the right issues. With SLBs, that is a more important point than with green bonds, namely the whole organisation’s future performance and strategy.

For SLBs themselves, the closest analogy in finance is the 125bp coupon step-ups that used to be common on bonds of triple-B minus rated European companies. The step-up was to be triggered by a downgrade to junk, or sometimes a downgrade that followed a change of control such as a leveraged buyout.

This in fact, as well as the rating-driven price variations in the loan market that spawned sustainability-linked loans, was the real antecedent of SLBs.

Investors liked bonds with the 125bp step-up because they knew a downgrade to junk was a real risk, and that the step-up would compensate them.

Bonds with such step-ups could therefore be priced more tightly than comparable ones that lacked them. So issuers used the structure. The product worked.

SLBs offer a similar advantage. So why are investors not paying up for them, and tempting issuers not to issue more of them? Why are they not clamouring for companies to issue them?

The fundamental problem is that, unlike with a rating downgrade, investors do not fear material financial loss from companies or governments missing their sustainability targets.

Away from SLBs, how many investors buying a corporate or government bond take a view on the probability of the issuer missing its sustainability targets? They certainly should — but mostly, they don’t.

The price behaviour of Enel bonds around its recent step-up is informative. The SLBs with rising coupons traded up. But its other bonds ― unprotected from any credit weakness caused by Enel's sustainability underperformance ― hardly budged, according to Tradeweb data.

And, quite honestly, why should they sell off, when Enel has merely failed to get the greenhouse gas intensity of its power generation down below 148g of CO₂ equivalent a kilowatt hour? The metric is at 160g instead, still down 30% on the year. It is still committed to this year’s target of 130g.

And what about the hundreds of companies that have never issued an SLB, but miss a sustainability target? Does the bond market punish them?

That is the central question.

A 25bp step-up is not too small. It's probably in the right size ballpark to compensate for any credit spread widening caused by missing a sustainability target.

But unlike put options on equity, or rating downgrade-related step-ups, the answer so far is that investors don’t value this hedge because they don’t fear the thing it compensates for.

The step-up is a free hit. They’re happy to take it but they won’t pay for it.

No wonder, when they are not losing sleep about all the non-SLB issuers in their portfolios, and whether they have set ambitious targets, or are going to achieve them.

SLBs are an attempt to give investors compensation for sustainability underperformance. When investors price sustainability underperformance, they will value that hedge ― but not before.