Environmental, social and governance (ESG)-linked bond structures have become very popular in investment-grade bond markets. We think the time is right for high-yield issuers to join in. For investors, that will create both new opportunities and analytical challenges.
ESG-linked bond structures have come a long way. From just US$243 million of green bonds issued cumulatively in March 2016, there were US$1.8 trillion of bonds cumulatively issued as of March 30, 2021, across a wide spectrum of green and other ESG-linked structures. But so far, the issuance has come mostly from investment-grade companies. That’s not surprising, because it takes scale to launch a project-based green, social or sustainability bond. For these categories, companies must identify a specific project large enough to warrant a dedicated bond issue.
Target-Based Structures Create New Opportunities—and Challenges
Even so, small and mid-sized high-yield companies need not be excluded from ESG-linked bond markets. A relatively new target-based ESG bond structure enables companies to issue bonds linked to specific firm-wide ESG improvement objectives. In this part of the market, companies can issue key performance indicator (KPI)-linked bonds whose performance targets can be tailored to their specific industry and circumstances. We believe this development creates an opportunity for high-yield companies—particularly those in “dirty” industries—to finance their transition to a sustainable business model.
To access this market, high-yield companies don’t need to commit to a specific capex project or projects. Instead, they need first to demonstrate strong sustainability credentials, and then to deliver on their sustainability commitments.
Because high-yield markets contain a high proportion of “old economy” businesses in manufacturing and extractive industries, target-based ESG structures could be attractive for a wide range of issuers. Cement or metal manufacturing companies could, for instance, access finance linked to a carbon-reduction plan using science-based targets compatible with a 1.5 degrees warming scenario.
But because KPI-linked bonds can provide an easy access point to new financing, and because their terms can be highly issuer-specific and varied, they can also present a higher risk of greenwashing. The challenge for investors is to discriminate between those issuers with a sound sustainability plan and a strong commitment to execute it, and those with a merely opportunistic approach.
An Analytical Framework Is Vital
Investors therefore need a robust, formalized framework to analyze issuers’ KPIs and to determine which targets are meaningful and which are just window-dressing. That, in turn, demands strong fundamental analysis to understand a company’s sustainability report and then link it to next steps in a way that can be readily quantified.
The first step is to understand the nature of the KPI, what it’s meant to achieve and how progress will be measured. That’s not a straightforward task, as there is a wide spectrum of KPIs, from water recycling to reduction in greenhouse gas (GHG) emissions. In each case, the KPI is supported by a set of sustainability performance targets (SPTs). It’s important to determine whether the SPTs are sufficiently relevant and material both for the issuer and the industry, and whether the intended improvements can be validated externally and benchmarked properly.
The next issues are the timeline for performance and the conditions if the KPIs are not met. KPI-linked bonds feature not only targets but also penalties. Typically, failure to achieve the KPIs by a given milestone date results in a step-up in the bonds’ coupon. In this way, disappointed investors will receive increased interest payments in lieu of the promised ESG improvements. But there will be no real incentive for the issuer to perform if the penalty is too small and/or the milestone date is too remote.
Also, many high-yield bonds are callable—meaning there’s a risk the issuer may be able to redeem early without incurring much of a penalty for missing their SPTs. This feature can be challenging for ESG investors in the high-yield market because call dates can be quite short, while SPTs may take several years to address fully. Accordingly, it’s important to check that the SPT timelines precede any call dates, so that issuers are fully incentivized to meet their targets.
Ongoing engagement with company management is vital to understanding these issues and to making sure both that structures provide the right incentives and that issuers are still on course to deliver on their promises.
Good KPIs Versus Bad KPIs
We believe that KPI-linked bond issuers’ targets should be ambitious. For instance, a components manufacturer recently committed to SPTs featuring 20%-plus reductions in GHG emissions within a 10-year timescale. That objective is material in the context of their industry peers. We also like that the company has committed to future bond issues in the same format. That’s because we want to see companies make long-term ESG commitments linked to a strategic plan.
By contrast, a recent KPI-linked issue in the extractive industries sector had relevant SPTs but no long-term corporate plan. This issue was also callable. In the worst case, the company might miss its SPTs and then redeem the bond early. In this scenario, investors would receive just one enhanced coupon before their capital was returned, receiving only 25 basis points (b.p.) of extra income. But in our view, when issuers fail to meet their SPTs, the penalty should be material. For instance, a 75 b.p. increase (equivalent to three coupons stepped up by 25 b.p. each) could be more appropriate. Alternatively, investors should expect to see a higher cash price embedded in the call as compensation.
The transition to a more sustainable world is a huge area of focus for investors worldwide. We think target-based ESG bonds have a critical role to play on that journey, particularly for high-yield companies. And once investors get smart about what to look for, corporates will adopt more stretch KPIs and make faster progress.
