The inclusion of ESG-linked coupon adjustment mechanisms is the latest fad to hit the European non-investment grade new issuance market. Emerging first in new-issue loan documentation at the end of 2020, we would now estimate around a quarter of all new non-IG bond/loan issuers are choosing to link interest payments to sustainability-linked targets in one form or another.
In the loans market, so far we’ve seen little in the way of standardization, which is perhaps not a surprise to those familiar with European leveraged loans. Targets, or KPIs, while naturally unique to each issuer, have not always passed the “smell test” in our reading, and it is difficult for our analysts to assess how achievable they are for corporate Issuers. While some loan issuers have included a framework for verification of progress against the target by an independent party, most have not. Some early examples included margin ratchets, which can only move down (!), although the standard looks to be evolving more lately to a +/- 15 basis-point change to margin. One loan issuer has even committed to donate 50% of any margin savings to charity!
The European high yield bond market looks to have adopted a more standardized approach, centered around a coupon step-up where issuers are penalized by 25 bps or even 50 bps in annual interest payments if predefined sustainability-linked targets are not met, as verified in most cases by an independent party.
We view any capital markets solution that incentivizes increased transparency and discussion on ESG topics as beneficial. Our worry is that issuers are supplanting the capital markets in reducing their cost of capital. There is a risk that, without sufficient disclosure and independent verification, this new capital markets solution could be viewed as a “free” reduction in coupon for the issuer, and that the issuer can decide to reward itself for actions that it was planning to take anyway. We view capital markets and independent analysis to be a better judge as to whether a company is a leader or laggard in ESG, and believe that, over time, companies that are leaders will be rewarded by the market.