Sustainable Junk - June 2022

Josh Latham
+Alex Manolopoulos

11 July 2022•9 min read

Following on from our Webinar ‘ESG Primer - Diving into Sustainability-Linked Deal Terms’ - we provide answers to a number of unanswered questions in this edition of Sustainable Junk.

Thanks to all who attended, a replay of the Webinar can be found using this link.

Q: What regulation is in place for Sustainability-Linked Issuance and is there any guidance on the structural flaws of SLBs?

In just over a year, sustainability-linked bonds (SLBs) have carved out their place in the green financing market, representing ~14% of total European High Yield issuance in 2021. The absence of market standards and regulation have allowed for looser documentation, however, which brings to light the structural issues with this debt type. Claims of greenwashing by investors may add further fuel to the fire, leading to slower adoption of SLBs in the future.

Calls for increased regulation and guidance have been raised, yet little has been done. The International Capital Market Association (ICMA) has laid some of the initial ground work in the area, but the guidance is voluntary and doesn’t provide a strict framework on structuring deals.

We’ve found signs of greenwashing in many forms in relation to SLBs, including coupon step-up sizes, KPI selection, testing dates and unambitious targets. Another major structural flaw is the ability of borrowers to refinance bonds prior to the selected testing date. This loophole enables borrowers to bypass the sustainability performance targets (SPTs) altogether, making them essentially obsolete. The ICMA has introduced new guidance in relation to this flaw, and is a step forward in terms of supporting the integrity of the SLB market.

The new guidance recommends that “the structure of any SLB requires their performance against at least one SPT be evaluated, prior to the bond becoming callable”. Where this is not practical, the ICMA says that “investors will likely expect the call price to reflect an assumption that the SPT has not been met”.

Under bond documentation a call schedule is set at issuance, and therefore ICMA’s recommendation of a call price penalty will need to be carved in then - we will discuss how this can be implemented later.

Generally SLB issuers have aligned their Green Financing Framework with the Sustainability-linked Bond Principles published by the ICMA. We’ve found the language below feature in all sustainability linked bond documentation except for Teva Pharmaceuticals, Nemak, Valeo & Constellium.

ICMA deputy CEO and head of sustainable finance, Nicholas Pfaff, said “We’re not regulators. On the other hand, I think what should be noted here is how specific the guidance now is, and how comprehensive and also how transparent it is. Investors will take a view and then at some point regulators might take a view”.

Alongside the guidance, ICMA has released a database of 300 KPIs that cover global and specific KPIs across E, S and G. ICMA also released an updated and expanded Q&A document for sustainability-linked bond principles.

Testing Dates Matter - Refinancing Risk

As displayed below, we find the majority of issuers are testing targets 50-75% through a bonds tenor. Having testing years 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.

The issuer with the closest testing date to today is Rexel, set for the end of 2023. The notes call schedule steps down in July 2024, and therefore we are unlikely to see the borrower refinance the bond prior to testing date.

We are able to look at historical duration figures in the European High Yield market to get an understanding on whether refinancing’s prior to testing is likely to occur. The average duration has been ~60% of a bonds tenor in the past (with data going back to 2009) whilst the average tenor was 6.4-years.

Interestingly, we found the average testing date as a percentage of a bonds tenor was 50%. Therefore, we can safely say that we expect some targets will be tested prior to redemption. Nevertheless, this option is still on the table for some borrowers who may want to bypass certain testing dates.

Criticism over this loophole has pushed ICMA to make specific reference to it in their guidance. Kem One introduced the first “Intermediate SPT” in November 2021, which hasn’t been replicated since. In this structure the issuer is tested annually against targets, which allows investors 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.

Regulatory frameworks in Sustainability Linked Loans

In addition, as we touched on previously, 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.

Of course, these principles act more as an informative framework, meaning compliance is at the discretion of the issuer / advisor structuring the deal. As we covered, 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.

SFDR Overview

The continued rollout of the EU’s SFDR will flesh out clear fund level and (increasingly) corporate level ESG disclosure requirements - establishing a baseline for disclosure using templates established under the Regulatory Technical Standards.

This standardisation of the frequency and content of ESG disclosure will help to more easily identify taxonomy non compliant issuers, giving the buyside transparency over the ESG credentials of their investments. In terms of recent developments, the European Commission has voted to include Natural Gas and Nuclear as sustainable energy sources under the EU Taxonomy - significant for issuers such as Rolls Royce who have an emerging presence in nuclear and the wide array of issuers in European LevFin who either directly deal in or are reliant on Natural Gas. The roadmap for the continued implementation of the SFDR can be seen below:

Q: Are you seeing any trends as to the application of any margin/coupon discount or premium from sustainability-linked instruments?

On the loan side, we have increasingly seen Sustainability Linked deals come to market with a provision stipulating that the issuer will make “reasonable efforts” to apply all or a portion of (we have seen 50%, for example) margin savings towards ESG investments, within a certain period (usually 12 or 24 months). The provision featured in ~25% of the SFAs/Term Sheets we reviewed for Sustainability Linked Leveraged Loans in 2021.

As we covered during our webinar in relation to ESG & Event of Default - in a similar fashion to the emergence of stipulations explicitly stating that failure to produce an ESG report would not constitute an Event of Default - we have also seen a provision stipulating that failure to apply margin savings to ESG investments within the stated timeframe would not constitute an Event of Default either.

However, with loose terminology such as “reasonable efforts” and some issuers having a long runway to make these investments (24-months in some cases), it is difficult to see how such a provision could be relied upon to claim an Event of Default in any case.

Q: Is there any observable greenium (pricing benefit) you have seen?

We’ve attempted to answer this question on numerous occasions, yet have been unable to show conclusive evidence that there is a greenium present in all ESG-linked deals. 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.

Research conducted by ELFA found that over half of the study believe a greenium is justified providing the structure and targets are robust and credible. As greater regulation is introduced, forcing sustainable financings to become more reliable, do we expect to see higher greeniums?

In February’s edition of Sustainable Junk we explored whether we’ve seen a greenium in past deals. In the case of Telecom Italia, we believed their Green Bond showed greenium features, after the borrower secured its lowest coupon ever, coming in at half their average cost of debt. See the relative value graph below:

When we looked at VodafoneZiggo’s SLB issuance, however, we found there was no clear evidence that the borrower received a premium compared to historical issuances.

Generally we haven’t found evidence to suggest there is a greenium in SLB issuance. However, investors may be willing to pay more for the perceived benefits of investing in green instruments. With the Sustainable Finance Disclosure Regulation (SFDR) coming into force from January 2023, yet more investors may be tempted engage in impact investing.

Selected 9fin ESG Highlights

9fin’s ESG filter has brought to light some important social and governance-related news items from the previous month which are worth highlighting:

An emissions scandal investigation into Continental has widened to include three people formerly in leading management roles at the company. The German automotive supplier could face a fines as a result of alleged aiding and abetting of fraud by omission
Mediapart reports Rexel created discreet structures intended to evade French tax. The €600m SUNs due 2028 fell 4.5 points to price at 80 following the news
The remuneration of the new CEO of Orpea will be closely linked to ESG. Concerns over Orpea’s operations emerged in January 2022 following the publication of the book “The Gravediggers”
Delivery Hero and Glovo have been raided by EU regulators over antitrust concerns

ESG QuickTakes & Primers

9fin publishes more detailed ESG analysis in ESG QuickTakes on new deals. If you are not a client but would like to request a copy, please click on the name(s) below and complete your details.