Clearly, sustainability targets in SLBs are intended to be set in good faith and, crucially, with the intention that attainment ought to be a ‘stretch’. A lack of the latter would be a major concern for ESG investors who buy into such instruments to help incentivise sustainability improvements at the issuer. Not surprisingly in this context, a number of investors have started to push back on redemption step-up structures (in a survey we undertook, 17% voiced concern on this type of incentive), arguing that target failure should allow investors to review their position during the bond’s tenure or engage the issuer. Redemption-based structures don’t provide for this as they only present target misses to investors as a fait accompli at the end of the bond’s lifetime.
Yet, missing a sustainability-linked target is not necessarily a negative. It may simply have proven to be too ambitious or not achievable within the defined timeframe, particularly in light of the geopolitical and economic shifts we’ve seen in the past two years. Arguably, (slightly) missing a target could in fact indicate that it was a well-calibrated objective, and could produce a better ESG outcome than achieving a non-stretching target.
Also, the evolution of the SLB market will benefit from some misses. Firstly, it could dispel the myth that a sustainability target miss would automatically turn an issuer into a “persona non grata” in the capital markets. Secondly, such misses can provide data points around the resulting impact on bond price, liquidity and investor behaviour. Issuers – and their advisers – could use this information in future structures by, for example, adjusting step-up clauses to more closely approximate for the advisable investor protection (potentially moving away from the common 25 basis points coupon step-up). Equally, investors can use the data for their pricing of step-up risk in related instruments, creating more visible option premia.
Overall however, we don’t expect a wave of SLB target misses in coming months. Based on our tracker of selected public SLBs in the European and US market, 86% were on track to meet their target at the end of 2022 – and many have re-benchmarking flexibility, as we covered in a previous article.
Yet, for those SLBs that experience target misses, context is important. Issuers should explain what strategic steps they had taken to attain the target, and why this proved insufficient – and how they reflect on their ESG strategy going forward. This will likely help restore the required sustainability credibility, because, as market participants know, no one has a crystal ball.
