Three ways to protect the sustainability-linked bond market

According to a new post in IDB Invest, Sustainability-Linked Bonds (SLBs) have become an important instrument in the debt capital markets and have the potential to completely redefine the sustainable debt market. These bonds give issuers much leeway in the use of proceeds, meanwhile market participants are better understanding the risks and rewards of these instruments. The main risks can be grouped into three main categories: weak and ambitious targets and KPIs, poorly crafted incentives, and structural gaps.

• Insufficiently robust and ambitious targets and KPIs: Since one of the criticisms SLBs receive relates to the targets and KPIs used for not always being ambitious enough and not having a scientific basis, the International Capital Markets Association (ICMA) partially addressed these objections, publishing a register of KPIs spanning more than 20 sectors, with the aim of providing market participants with other tools to better design and assess the materiality of KPIs, thereby increasing transparency and integrity of the SLB market.

• Improperly crafted incentives: To decrease potential moral hazard for investors (earning higher returns from missing KPIs) investment firms need to create and adopt a robust impact framework that thoroughly assesses SLB instruments (including KPIs and Sustainability Performance Targets (SPTs)), their compatibility with one’s environmental, social and governance (ESG) strategy, as well as other inherent risks for sectors and individual issuers. The solution lies in ensuring that the potential coupon increase has an impact on the financial conditions and credit profile of the issuer, thus creating significant incentives for companies to set targets as a strategic priority. A creative solution to highlight is the case of Uruguay, which pioneered by launching the world’s first SLB with a two-way coupon structure (ie, up, down, or no change).

• Structural loopholes: have occasionally been exploited by issuers to circumvent the consequences of failing to comply with the SPT. To avoid them, issuers must set stricter requirements, and investors must also demand them, for example that the triggering events are set no later than half of the period from the issue date to the maturity date or the redemption date anticipated, whichever occurs first. Include a contractual provision that requires any voluntary purchase option exercised prior to the verification date to include the coupon increase, unless the targets have been met in advance.