Sustainability-Linked Bond flavours: new mechanisms move beyond the “plain vanilla”

While much of the debate around Sustainability-Linked Bond (SLB) structural integrity has focused on the quantum of coupon steps, their mechanisms are equally evolving – and those require careful scrutiny, too.

05 Oct 2023 . 2 mins read

So, how are SLB mechanisms developing? Rather like an expanding ice cream parlour, we’re moving beyond the “plain vanilla” flavour. To recap, “plain vanilla” is a step-up structure where the step-up coupon period starts at the full interest period after the key performance indicator KPI report is published.

Take for instance a 7-year bond issued today with a 2025 Year End target and annual coupon payments:

A. 31st December 2025: Observation date for target

B. 30th April 2026: KPI report is published. Assuming target is not met

C. October 2026: Start of step-up coupon period

D. October 2027: First step-up coupon is paid

E. October 2030: Final step-up coupon is paid as part of redemption payment

Coupon step-up sequencing: illustrative cashflow payments

Souce: NatWest

Certain recent structures have adjusted this sequence in various ways: We’ve seen bonds, where steps C and D are brought forward by 12 months (or 1 interest period), meaning the first coupon step-up is paid a few months after the KPI report. While this offers investors a more immediate economic reward, it could complicate secondary market trading. The accrued interest in the “dirty” price of the bond could suddenly increase post step B, the publication of the KPI report (as, in case of failure, the step-up quantum should then be incorporated in this accrual).

Similarly, SLB structures have been agreed where steps C and D are delayed by 12 months or more (i.e. in this example to 2028 or 2029). While this helps manage cumulative step-ups, market participants have also argued it reduces the “response mechanism” inherent in the instrument. This is certainly the case when compared to sustainability-linked loans, where margin adjustments occur every year.

Other SLB mechanisms are omitting step E (step-up at maturity). While this can help back-solve for a preferred cumulative step-up, it can risk looking arbitrary – note that convention for bond step-ups is to apply for the remainder of the lifetime of the bond (unless, in the case of sub-IG step-ups, a remediating event has occurred).

Finally, there are cases where steps A to E are subject to a cap. This is more common where there is a material delta between step B and E in terms of number of years. The buy-side can again risk being caught off-guard when a step-up interest payment “suddenly” ceases to be received.

While these different iterations can have their merits in achieving specific issuer and structuring objectives, they do come with some risks – as outlined. Therefore, careful communication at the marketing and book-building stage is crucial, allowing for an honest exchange of views. And, in doing so, avoids leaving a bad aftertaste!

For more on the latest themes and events shaping the Sustainability-Linked Bond (SLB) market, check-out our quarterly SLB Watch Note.

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Sustainability-Linked Bond flavours: new mechanisms move beyond the “plain vanilla”

Coupon step-up sequencing: illustrative cashflow payments

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