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In this edition of 9fin Educational, we take a look at Sustainable Finance, exploring the structural features and key focal points when reviewing these deals.

Sustainable financings have carved out their place in the European High Yield and Leverage Loan market, representing ~25% and over 20% of overall issuance in 2021, respectively. As more investors look to align their portfolios with internationally recognised sustainability goals such as The Paris Agreement or UN Sustainable Development Goals (SDG), the use of sustainable finance will become increasingly important.

What are the different fixed income sustainable products?

A Green Bond, otherwise known as a ‘Use of Proceeds’ bond, funds projects or operations with dedicated environmental or climate-linked benefits. These projects will usually be defined in the ‘Green Financing Framework’ that borrowers issue alongside the offering documents.

Although proceeds don’t have to go directly towards a project (we’ve seen proceeds go towards LBO’s, Refinancing and Acquisitions) the borrower will allocate an amount equal to net proceeds during the lifetime of the bond.

Unlike Green and Social Bonds, sustainability-linked structures have no restrictions on use of proceeds. The instruments instead include sustainability performance targets (SPTs), which test the borrower on certain ESG KPIs. If the company fails to meet the target, a penalty will be triggered. In European High Yield, the size of this ratchet has ranged between 12.5 bps to 75 bps for a single target. Sustainability-linked products first appeared in EHY when Public Power Corporation came to market in Q1 2021.

Sustainability-linked structures are by far the most common ESG structure we have tracked in the European Leveraged Loan space, having been a frequent feature in issuance since 2020.

There are a number of notable differences between sustainability-linked structures in HY and in leveraged loans. Firstly, rather than a “coupon step-up” mechanism, meaning a one way penalty for failure to meet the stipulated SPTs, leveraged loans most typically contain a “margin ratchet” instead. The difference here is that, as the name implies, the “margin ratchet” mechanic works both ways - meaning that if an issuer meets their SPTs, the margin on the loan will step down by the stated amount (most typically 7.5 bps-15 bps). This means that in conjunction with a sizeable leverage ratchet, commonly 25 bps, buysiders can see their coupon payments significantly impacted by the triggering of these ratchets.

Turning back to Sustainability-Linked Bonds, we have monitored a clear growth in SLB popularity amongst borrowers. We believe the increase in adoption is based on the lack of restrictions on how the proceeds of the notes can be used, in comparison to other fixed income sustainable products (such as green bonds) which have a firm mandate on the use of bond proceeds. This flexibility has allowed for a broader range of borrowers to access the ‘ESG financing’ market - even those that don’t have a particularly good ESG profile. However, on the loan side we are increasingly seeing provisions which stipulate that issuers will make “reasonable endeavours” to apply any cost savings from a margin step down to ESG initiatives. Of course, “reasonable endeavours” is not a clearly defined term.

The targets attached to sustainability-linked instruments are ultimately decided by the company, and the KPIs are calculated on a ‘good faith basis’. Due to a lack of standards and regulation surrounding targets, company’s have been accused of Greenwashing through the use of unambitious and immaterial targets. We will discuss Greenwashing in more detail later.

Targets incorporated in SLBs have been fairly vanilla, with every issuer incorporating environmental-based targets, and the majority choosing a reduction in absolute emissions. The only Social target was used in Teva Pharmaceuticals deal, and no borrower has incorporated Governance targets to date.

In comparison, loans issuers have been more creative, featuring an array of targets across ESG issues. We’ve also increasingly seen issuers coming to market with “option to include” clauses - having no ESG terms defined during syndication, but leaving the door open to this in future. Of course, this reduces the transparency during syndication of ESG metrics & future targets, making it more difficult for buysiders to gauge the ambition of the issuer in this regard. Usually the addition of this ratchet would be subject to majority lender consent, but we saw Caldic try to push for no majority lender objection instead, which was reverted during syndication back to the market norm of requiring majority lender consent.

We’ve seen a variety of penalty structures which have varied amongst bond and loan issuances.

In bonds, the coupon step-up has been the most popular mechanism - featuring in 90% of deals. The coupon penalty that borrowers face for failing to meet targets has ranged from 12.5 bps to 75 bps for a single target. However, looking at the ‘maximum’ margin ratchet, which is defined as the penalty for failing all targets, shows a coupon step-up of 25 bps is the most widely used financial penalty.

We have also seen the redemption premium mechanism used in a handful of deals, including Kem One, Webuild & Itelyum. A redemption premium is an amount paid over the par value when an issuer comes to redeem/refinance a bond. You can read our take of this mechanism in full, in Dude, Where’s My Coupon Step-Up?.

The coupon step-down, which are universally seen in leverage loans, has only featured in one High Yield bond deal - VodafoneZiggo’s Jan 22. In theory, a coupon step-down rewards the borrower for achieving the target, and is often the same size as the coupon step-up.

If we take a look at loans, we have observed smaller ratchet sizes ranging from 2.5 bps to 15 bps for a single target. Additionally, rarely we have seen issuers come to market with margin ratchets which are not symmetrical, meaning the threshold to reduce the margin is lower than the threshold to increase it. For example, Roompot’s September 2021 issuance came with a 15 bps ratchet linked to three KPIs, but the issuer only had to achieve two of these targets for the 15 bps downward ratchet to kick in, reducing the margin, whereas the company would have to miss all three targets for the 15bps ratchet to kick in and increase the margin.

Similar to targets and penalties, testing dates are decided by the borrower. In bonds we find the majority of issuers have testing dates placed 50-75% through a bonds tenor. Testing closer to maturity minimises the impact of a potential coupon step-up. On the other hand, if the target is ambitious it should require adequate time and resources to complete, so you could argue testing should take place further along the bonds tenor.

It is important to note that borrowers are able to change or alter the KPIs, Testing Date or Baseline under certain circumstances. These include business divestments, change of control and access to better data.

Sustainability-linked adjustment details can be found on 9fin’s instrument page. For example Europcar SLB issuance:

A major structural flaw of SLBs is that borrowers are able to refinance, due to their call schedule stepping down, before the testing date occurs. This loophole enables borrowers to bypass the sustainability performance targets (SPTs) altogether, making them essentially obsolete.

Structural features used to mitigate this refinancing risk have been introduced. Kem One incorporated the first “Intermediate SPT” in November 2021. In this structure, the issuer is tested annually, in order to monitor the trajectory of the target before the testing year. If the borrower was to refinance the bond prior to the testing date, and hadn’t met the Intermediate SPT, then a redemption premium (in this case 25bps) would apply.

A greenium occurs when companies issue ESG-linked debt and gain funding cost advantages (lower coupon) compared to their vanilla debt. We analysed whether we’ve seen a ‘Greenium’ in Green Bonds and SLBs in February’s edition of Sustainable Junk. But to summarise, we believe some Green Bonds have shown greenium features. Meanwhile, we haven’t been able to show evidence that greeniums are found in SLBs. As the market grows there will be more data to show whether a greenium does occur in European High Yield, and if so, how big the greenium is.

So why would a greenium occur? Firstly, we believe oversubscription during the book building process has lead to more aggressive spread compression. We noticed multiple Green bonds, including Getlink (5x oversubscribed), ZF (6x), Neinor Homes (5x) and Paprec (4x).

Another explanation is that Investors are rewarding companies (through a lower coupon) who show commitment to reach sustainability targets, whilst communicating ESG issues through frequent report.

We have been unable to present any evidence to support finding a greenium in SLBs. However, a recent study by University of Zurich titled ‘Who Pays for Sustainability? An Analysis of Sustainability-Linked Bonds’ suggests that companies may have found a ‘free lunch’ when issuing SLBs. The research found that, on average, the penalty for not achieving KPIs was around 25 bps. Meanwhile, they found that issuance itself was often issued at a premium of close to 30 bps compared to the issuer’s similar unlabelled bonds.

It is important to note that costs associated with hiring second party opinion providers and filing for ‘green’ certificates will eat into any greenium a borrower acquires.

The pushing of very weak, superficial sustainability claims merely for appealing marketing and favourable rates is known as greenwashing. In terms of Sustainable Finance, we’ve seen greenwashing appear in many forms, with investors scrutinising ratchet sizes, KPIs and testing years.

When looking at instruments, we’ve found the use of unambitious and immaterial targets to be the biggest controversy surrounding sustainability-linked instruments. Review our Red Flag Review Checklist later on in this educational piece to find out how we assess these targets.

To reassure investors companies hire second party opinion (SPO) providers. These independent companies typically evaluate targets and assess a company’s ESG profile. With regards to targets, SPO’s will measure the relevance and ambitiousness of targets using certain criteria, which will then be reproduced in a SPO report.

It is important to note that these external companies are not currently subject to any specific regulatory or other regime oversight, and we feel your own judgement is needed when analysing targets.

The European Commission launched its proposed EU Green Bond standard in July 2021, which is intended to be a gold standard for green bonds. This would allow borrowers to use the designation ‘EuGB’ if certain requirements are met, including:

Taxonomy-alignment: Use of Proceeds are aligned with the EU Taxonomy

Transparency: Full transparency on how the proceeds are allocated through detailed reporting requirements

External review: Bonds must be checked by an external reviewer to ensure compliance

Supervision: External reviewers providing services to issuers of green bonds must be registered by the European Securities Markets Authority

The Commission proposed that it would be a voluntary standard, which could co-exist alongside existing standards such as the International Capital Market Associations (ICMA) Green Bond Principles.

Due to the market’s infancy there is a lack of regulation in the sustainability-linked market. Instead borrowers will generally align their Green Financing Framework with Sustainability-linked Bond Principles (SLBP) published by the ICMA. We’ve found the language below feature in all sustainability linked bond documentation except for Teva Pharmaceuticals, Nemak, Valeo & Constellium.

On the loans side the LMA has established a set of Sustainability Linked Loan Principles, which outline how Sustainability Linked margin ratchets should be structured and how a prospective issuer should select both KPIs and performance targets to link to these ratchets.

As with the SLBPs, these principles act more as an informative framework, meaning compliance is at the discretion of the issuer / advisor structuring the deal. Compliance with these principles has varied widely, predominantly in the selecting of KPIs which are relevant to the business, paired with sufficiently ambitious performance targets.

More broadly, the continued rollout of the EU Taxonomy through January 2024 will raise the ESG disclosure bar for financial market participants, defining three clear buckets of ESG ambition for financial products:

Article 6: No integration of ESG considerations in the financial product

Article 8: The financial product accounts for ESG characteristics as part of its investment decision

Article 9: The financial product has sustainable investment as its core objective. Currently, this core objective can only relate to carbon emissions, but planned regulatory rollout will expand the article 9 definition to also include other social, governmental and broader environmental objectives

Eurosif’s roadmap for the rollout of the EU Sustainable Finance initiative is below:

What should you look out for in reviewing sustainability performance targets? The following is intended to be a shortlist to help you focus your review on the key points.

Targets should reflect crucial sustainability problems that the issuer is facing

KPIs should be well-documented and verified by independent parties

Climate-related KPIs should cover the key emission scopes (i.e. Scope 1, 2 and 3)

Historical figures and the baseline should be accurate and fair

Climate targets should be aligned with Science-Based Target Initiatives (SBTi)

As part of 9fin’s ESG content we publish regular ESG QuickTakes on borrowers, as well as ‘Sustainable Junk’ - a monthly round up of ESG-linked debt analysis and news. 9fin also allows clients to filter for ESG-related news on our Dashboard & company pages (e.g. INEOS). If you would like more information about our ESG-related data and analysis, please get in touch at team@9fin.com 

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