Uruguay is considering selling a sustainability-linked bond with two-way pricing that will introduce a stepdown in pricing if the country hits environmental targets as well as a more conventional step-up if it misses them. The potential deal is reigniting a long-running debate around the use of the structure in the bond market.
Two-way pricing has been a feature of the sustainability-linked loan market since its inception in 2017 and is used to incentivise borrowers to decarbonise as well as penalise them for missing targets, but bond investors have adamantly refused to accept any stepdown structures to date since the first SLB in 2019.
"We must have two-way pricing for the sovereign market. I think that is the most robust framework that can exist, and I think it would be the next step in ensuring ESG risks and opportunities are properly integrated into the sovereign market,” said Anjuli Pandit, head of sustainable bonds for EMEA and the Americas at HSBC. “It must be an option for sovereigns to have that as an asset class."
Uruguay is currently sounding out investors about a two-way pricing structure as it sees a mix of rewards as well as penalties as a better alignment of incentives for a sovereign borrower after flagging the "innovative financing mechanism" in an investor presentation in May.
The framework has not yet been completed for a deal, and timing of an issue is unclear due to market volatility, but discussions are making some headway and bankers remain hopeful.
“We’re trying to get a clearer sense of whether or not investors could accommodate this. It’s pretty challenging for a whole number of reasons, but it’s not a hard no,” a head of ESG DCM said.
Sovereigns more suitable
Bond investors have rejected two-way pricing on SLBs from the outset of the market in 2019, primarily on the grounds that they have a fiduciary duty to bring in as much money as possible for their end-investors.
But some believe that a sovereign issuer could find better traction and that SSA buyers could be more flexible. "It is disappointing that investors are not accepting two-way pricing on SLBs. Our hope is with sovereigns," Pandit said.
Italian utility Enel explored two-way pricing on the first SLB issued in September 2019, but ultimately decided against it after extensive market soundings.
“We were well aware that some investors could not accept stepdown bonds into their portfolios. We therefore decided to structure a trade that had a step-up mechanism only,” said Alessandro Canta, head of finance and insurance at Enel.
“We continue to support the growth of the sustainability-linked finance market, whether it is characterised by the presence of step-ups combined with upfront discounts, or whether it brings new structures characterised by the presence of both step-up and stepdown.”
The structure could be particularly well suited to emerging market sovereigns due to the larger coupons on offer and the fact that their deals are not bought as liquidity tools for investors’ portfolios.
Discussions with SSA investors are making some progress, particularly sovereign funds, rates funds and emerging market funds that already have sustainability strategies and climate strategies in place and are considering which countries are climate leaders and laggards.
"SSA investors – primarily rates portfolio managers and emerging markets investors – do not have the same strictness in their criteria as credit portfolio managers who are investing in investment-grade corporates. They have not pushed back as much," Pandit said.
Some investors in sovereign debt are wary of being seen to benefit from sovereigns falling behind on their climate targets (especially as the step-up payments would be funded by taxpayers) and believe that also offering rewards for success via two-way pricing provides a fairer solution.
In February, Chile became the first (and so far only) sovereign to issue a sustainability-linked bond, but more sovereigns are expected to follow, including Ghana which has included language in its framework to issue SLBs connected to developments in healthcare and education.
Although ESG-labelled debt issuance has slowed this year in line with the broader markets after Russia’s invasion of Ukraine, SLB issuance recorded a 6.7% increase in the first half of the year – to US$43bn, compared with US$40.3bn in the first half of 2021, according to Refinitiv data.
Corporates to follow?
A successful two-way sovereign SLB could reopen the discussion about the structure in the corporate market. And while investors continue to wrestle with the possibility of having to accept lower returns, paying to incentivise change could help to counter greenwashing allegations. “I think it’s potentially a very, very compelling structure. Frankly if we get one over the line, every government on the planet should be looking at these things,” the ESG DCM head said.