Sovereign Issuances the Next Big thing for Sustainability-Linked Bonds

As sustainability-linked bonds (SLBs) head ‘to the moon’ (about +918% in 2021 vs 2020), they’ve enjoyed wider adoption by private sector issuers as opposed to sovereigns and municipals who have been almost absent from the SLB space since the instrument made its debut about three years ago.

Private sector issuers that have flocked to SLBs have hailed their ability to facilitate general purpose financing versus the restrictions use-of-proceeds (UOPs) instruments such as green bonds and social bonds impose. For issuers in industries that do not typically have sufficient volumes of eligible assets to issue UOPs bonds, SLBs serve as a handy alternative to make inroads into the sustainable finance market, especially in an environment of increasing investor demand for ESG assets and heightened regulations.

Why Sustainability-Linked Bonds?

In addition to the so-called ‘greenium’ (reduced cost of capital aka green premium) that comes with issuing UOPs and SLBs, sovereigns like corporates will see several other advantages from tying their debt programs to sustainability performance metrics. Primarily, when the financial mechanism of a sovereign SLB is structured as a coupon step-down, countries that are committed to achieving the underlying performance targets can see their level of indebtedness drop over time as investors reward them by demanding reduced coupon payments. The greenium in this case is almost certain and differs from what is observed during the pricing of UOPs bonds because the potential for reduced coupon payments is contractually locked in the bond structure.

And as Fitch recently opined in a recent commentary on the benefits of sustainable bonds for sovereigns, ‘lower cost of borrowing and more stable sources of financing can be positive for creditworthiness if sufficiently material’.

Further, SLBs will enable sovereigns allocate the proceeds from sustainable debts to the entire economy. This way they have enough liquidity to allocate funds to sectors of the economy that may lack adequate eligible assets and can also support regular government activity while working to achieve their sustainability targets.

Scarcity of Sovereign SLBs

Despite these benefits, there’s little record, if any, of a national or sub-national government that has issued an SLB apart from the City of Helsingborg in Sweden. A major drawback is the perceived complexity of structuring SLBs compared to UOPs.

The argument is that identifying the right set of performance indicators that fit best market practice and guidance such as ICMA’s Sustainability-Linked Bond Principles is more arduous than mapping assets against eligible categories in Green Bond Principles and other UOPs instruments.

Crossing the SLB hurdle, robustness and materiality of KPIs and SPTs are sacrosanct

I believe that sovereign issuers can look to the examples of corporate SLBs that have been issued to date for lessons on how sovereign SLBs can be structured to gain market appeal. More specifically, investor concerns about the ambitiousness of targets and the materiality of KPIs would also need to be considered.

The World Bank recently released a set of recommendations in a report – Key Performance Indicators for Sovereign Sustainability-Linked Bonds that is aimed at providing constructive thoughts around the uptake of SLBs by sovereign issuers. Although the report focuses on the environmental KPIs, the principles are essentially the same irrespective of the thematic nature of the KPI. What I have done in the chart above is map ICMA’s guidelines on the choice of KPIs for SLBs and the recommendations from the World Bank report. These criteria highlight the importance of transparency if SLBs must deliver on their promises.

?While KPIs could come in different forms based on the thematic area, methodology for determining the metric (e.g., absolute vs intensity, the source (internal vs external), perimeter (e.g., geographic vs. business units), market participants have been paying attention to the specific sustainability contexts of SLB issuers. This is an important element for sovereigns to consider when developing their SLB frameworks and structures. For example, a simple binary KPI such as ‘submitting a Nationally Determined Contribution to the UNFCC’ may not be judged favorably by investors who will see it as within easy reach. Other investors may also hold back, arguing that such a KPI fails to provide room to measure intermediary progress over the tenor of the facility and may not translate into real impact.

Your bond your word, a question of accountability

Corporate executives and management boards may change without major concerns for SLB bondholders, but a dilemma arises when a new government veers off from the policy roadmap that should lead to the realization of the SPTs established in an SLB framework. How do investors react? Do they simply trigger the step-up (in the case of a step-up mechanism), thus penalizing an entire population that ultimately carries the debt burden?

What do investors do when a government disingenuously interferes with the process of measuring and reporting the performance of KPIs and SPTs tied to SLBs?

I believe that market participants will need to be innovative when structuring sovereign SLBs so that the instrument does not lose its integrity. Again, a better understanding of the context of issuers in terms of the strength of domestic institutions, rationale for the issuance, and strategy to achieve the SPTs will be crucial. This way, tailored sustainability financing frameworks, and clauses can emerge while maintaining the fundamental principles of established guidelines for sustainable finance instruments.

Moreover, the World Bank is already spearheading discussions about a verification platform for sovereign sustainability-linked bonds, an initiative that will be beneficial to investors and issuers as the quest for legitimacy and credibility in the sustainable finance market increases.

A lesson from Helsingborg

In what seems to be the first SLB from a government (sub-national government) issuer, the city of Helsingborg in Sweden issued an SLB in January 2022 based on a framework that was verified by S&P. The table above shows the main features of the framework and how it aligns with ICMA’s Sustainability-Linked Bond Principles. Clearly, the advisors who worked on this framework had put significant thought into selecting a KPI and an SPT that are aligned with best market practice.

And a robust verification mechanism with precise corrective measures was also set up for different scenarios that may affect the evolution of the KPI and the SPT.

Outlook

Going by the amount of work multilateral agencies like the World Bank are doing to facilitate the rise of sovereign SLBs and recent announcements of some national debt management bureaus, 2022 might as well be the year for sovereign SLBs to kick off. There is news that Uruguay is ‘working on a bond whose funds will not be designated for a specific purpose, but will instead pay for different initiatives, and at a variable interest rate’. Separately, in an interview with Environmental Finance last year where he hinted at a possible SLB issuance from Chile, Patricio Sepúlveda Carmona, head of Chile debt office stated, ‘we have had two years to explain our sustainability story – not only the ‘green’ dimension but also the ‘social’ dimension – I think it is easier for a country like Chile to got to the next step of issuing an SLB.’

?While experience with issuing a use of proceeds bond has its merits, it is not a prerequisite for issuing an SLB. And I reckon that sovereigns who launch into the sustainable finance space with the right SLB foot forward will not get less of a warm reception than peers who have issued UOPs bonds.