Do sovereign SLBs add up?
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Do sovereign SLBs add up?

Uruguay reignites the debate on transition finance with its sovereign sustainability-linked bond.


In October, Uruguay came to market with a $1 billion sustainability-linked bond with a potential 15 basis coupon step-down if the sovereign can outperform on its two sustainability key performance indicators. As expected, the feedback on the deal was polarised: some celebrate the innovation, while others are more critical.

Uruguay’s $3.96 billion order book saw demand from 188 global accounts including 40 new lenders, leading to a final spread of 170 basis points, according to Refinitiv.

But for ESG investors, the issuance also brings back reservations about the legitimacy of the SLB structure as a sustainable transition investment product.

Betting on a target

The sustainability-linked bond was originally created to address one of the market's concerns about the use-of-proceeds model: is it enough to invest in bonds that fund the sustainable projects of an issuer who has not established transition pathways for its other operations?

The instruments are a mechanism for an issuer to demonstrate a holistic approach to transition that goes beyond the assets on its balance sheet. This can make sense for an emerging-market sovereign issuer such as Uruguay, which wants to demonstrate a commitment to sustainability while securing broader debt financing.

The funding structure is based on an understanding between the issuer and investors that the KPIs impact the credit in the long term. For this mechanism to work, however, the targets must be ambitious and credible enough to please both investors and public opinion.

Even with secondary verification, the subjectivity of this structure continues to worry investors and deter market growth.

The 2025 maturity leaves a very short window for government policy to effectively impact GHG emissions or natural forest protection in time for the evaluation

Having drawn up the SLB principles in 2018, the International Capital Market Association (Icma) put together a list of 300 recommended KPIs, categorized by sector and split between core and secondary.

“Targets should be set, at a minimum, to be in line with official country/regional/international targets [...] and, when possible, shall aim to go beyond such levels,” the principles say.

On paper, the targets set by Uruguay should meet ESG investors’ mandates for green strategies: the country will reduce aggregate greenhouse gas emissions by 50% by 2025, using 1990 as the reference year, potentially outperforming its naturally determined contribution (NDC) to the Paris Agreement if it goes beyond a 52% reduction.

The second sustainable performance target (SPT) – to maintain 100% of native forest areas, using 2012 as the base year, and attempt to increase the surface area by 3% – was decided to please market demand for nature capital SPTs.

But the target timeline is incompatible with what the issuer can practically achieve over the tenor of the deal. The 2025 maturity leaves a very short window for government policy to effectively impact GHG emissions or natural forest protection in time for the evaluation.

On the emissions side, it is unlikely that current policies could dramatically reduce the level of GHG emissions in the next three years, which suggests that if the SPT is met, it would be a result of measures put in place since 1990, not since the bond was issued.

Similarly with forestry management, the national strategy was set out in 2018, and reports have already shown a cumulative increase of naturally regenerative forest surface area between 1990 and 2020.

This doesn’t mean that the country’s sustainability efforts are insufficient, but only that the success of the bond is based on the issuer’s reputation as an infrequent but secure dollar issuer, with well-established ESG credentials.

Contradictory mechanisms

This is where the coupon mechanism comes in, as an incentive to keep the issuer on track.

You could argue that the step-up, usually around 25bp, is not impactful enough relative to the size of the bond. The SLB principles state: “It is recommended the variation of the bond financial and/or structural characteristics should be commensurate and meaningful relative to the issuer’s original bond financial characteristics.”

Without a fixed number, issuers get away with an affordable penalty. The SLB product is marketed as an issuer-level commitment, but as the Uruguay example shows, it requires punitive and incentivising mechanisms for the issuer to stay on track.

On the buy side, the difficulty for investors is around labelling, and whether the fixed income product can legitimately be labelled as impact investing, ESG-compliant, net-zero, green, or even sustainable.

The greenwashing risk is even more acute for sovereign issuers where the SPT are at risk of being abandoned with any sudden policy or administrative change.

But if Icma were to become more restrictive and narrow the options in the selection of KPIs, in penalty and incentives, or even in the labelling, it would take away the flexibility of the SLB as a mode of financing the sustainable transition of hard-to-abate sectors.

Uruguay’s SLB might have attracted new investors with an appetite for Latin American fixed income with an ESG benefit, but it will not be enough for investors who want their capital tied to direct impact.

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