The already colouful world of leveraged debt is just getting to grips with green finance, but the pace of issuance is picking up fast. Junk-rated issuers have placed €20bn of sustainability-linked debt in Europe so far this year, more than eight times the figure for the whole of 2020.
While this is an impressive spurt, it comes with teething problems. Many of the sustainability-linked high yield bonds issued to date have ESG targets that aren't due to be tested until after the first call date. This is problematic, as many of the bonds will be refinanced at first call and so will never have their ESG performance evaluated.
Some also fear the targets themselves are not ambitious enough. As one senior high yield investor put it: “The targets often have no teeth.” Others worry about the lack of disclosure offered on ESG reporting.
Buy and sell side largely agree that it is important to integrate sustainable finance into the market. But at the same time, they seem to accept that ESG considerations will be a relatively low priority when executing deals.
With all of the necessary scrutiny over high yield terms — which Ebitda add-backs to allow, where to place limits on restricted payments or further debt issuance — ESG issues are often at the back of the priority line.
From a purely economic point of view, this stands to reason. Why would ESG issues be top of mind when the step up margin is negligible — on average around 20bp to 30bp? For borrower and investor alike, there’s not much skin in the ESG game. Moreover, high yield bonds typically only have a step up ratchet. With no step down feature, an investor can benefit from a company not hitting its targets, and only marginally at that, but there is no incentive for the issuer to go above and beyond.
What if failure to hit an ESG target resulted in default? It might sound extreme at first, but it would catapult sustainable finance to the top of the agenda and demonstrate a company's true commitment to improving its sustainability.
Neither the issuer of a bond nor its investors want a default to happen. And yet technical default is already the consequence for missing an interest payment or breaching a financial covenant. These restrictions are put in place with the expectation that a default will not be triggered. Why not take the same approach with sustainability covenants? A default is a serious matter, matching the seriousness of climate change, and would be a good way of truly holding a company to account on its sustainability goals.
The introduction of sustainable finance to leveraged credit has been a meeting of minds. Sustainable finance was nurtured in the placid world of investment grade credit, where it was allowed to evolve without any predators. Leveraged finance has a more creative culture, offering participants regular opportunities to innovate.
Making an ESG miss an event of default is a truly radical idea, and one which could put leveraged finance at the vanguard of sustainability.
