SLB hybrids - aligning non-call date and sustainability KPIs

The first article of this series introduced the potential interaction of two growing asset classes: Sustainability-linked bonds (“SLB”) and corporate hybrids.

KPIs used in the Senior market

In the Senior SLB market, the most common sustainability KPIs so far are Carbon / Greenhouse Gas (“GHG”) emission reduction and Renewable Energy, followed by several other categories (Chart 1). This is mainly due to the availability of well-established methodologies to assess the benefits of these KPIs relative to the historical performance of the company. In addition, in the European market, Senior SLBs from companies with environmental KPIs can benefit from their eligibility as collateral for Eurosystem credit operations and for outright purchases.

Chart 1: Main KPI categories in Senior SLBs

Source: NatWest analysis of sustainability-linked bonds issued in USD, EUR, GBP as of 31 December 2021.

Potentially suitable KPIs for a hybrid instrument

We believe that the above KPIs could be used in hybrid transactions, particularly given that there is a significant overlap between the Senior and hybrid investor base. Similarly, how in case of green (sustainable / social) use of proceeds bonds, the projects used in Senior are often the same as in hybrid instruments. In practice this would be the most efficient route to use the same KPIs, because Issuers could use their existing sustainability-linked financing frameworks.

Sustainability Performance Targets (“SPT”) used in Senior SLBs

On average, SPTs are observed 5.2 years after the issuance of the Senior SLB, while the average tenor is 8.2 years, thereby falling in the second half of the bond life (Charts 2 and 3). From a corporate finance perspective, the choice of the maturity of a bond should be driven by the treasury needs, rather than the availability of intermediate targets.

Coupon step-ups remain the market standard, with +25 bps the most adopted financial incentive; albeit some Issuers have experimented with a larger quantum. The annual step-up however, only tells one side of the story and the remaining number of coupon payments must be considered to fully assess the materiality of the financial incentive. To date the cumulative total penalty tends to vary, with many structures embedding 50-100bps as the debate on what constitutes a meaningful size continues with the investor community.  

Chart 2: Target year as a % of overall tenor in Senior SLBs

Source: NatWest analysis of sustainability-linked bonds issued in USD, EUR, GBP as of 31 December 2021.

Chart 3: Years from issuance to target in Senior SLBs

Source: NatWest analysis of sustainability-linked bonds issued in USD, EUR, GBP as of 31 December 2021.

SPTs that could be used in a hybrid SLB

As a reminder, a typical corporate hybrid instrument has an Issuer call option between 5 to 30 years after issue - the point where there would be a loss of S&P or Fitch equity credit. Last year average call date of hybrids issued was ~7 years; hybrid instruments are typically replaced at that point.

One question is whether existing Issuers in the Senior SLB market can “match” the SPTs on a potential new SLB hybrid with their existing SPTs in Senior.  In principle, there should be no reason why not, with two further considerations:

  • Existing Senior SLB targets could be too short (e.g. in 1 year) or too long (e.g. in 10 years), and thus difficult to align with the common hybrid non-call period
  • In addition, perhaps more importantly, given the need for a coupon step-down mechanism, investors may require more ambitious SPTs (and potentially even KPIs) in an SLB hybrid compared to a Senior SLB

SPTs to be observed before the hybrid call date

In a potential SLB hybrid, a key consideration would be the date at which the SPT would be observed. In order for the structure to have an economic impact, the SPT would need to be observed before the first call date of the hybrid. Otherwise, an Issuer could call the bond before measurement of the KPI, making the SPT test effectively redundant.

On the other hand, similar to Senior SLBs, observation should not be too close to the issuance date, as this would not allow the company to make material progress towards the stated target.

Given coupon step-down, SPTs to be observed close to the hybrid call date

There should be some period (at least 1 year) between observation and the call date to allow the coupon step-down feature to take effect. Given the novelty of the coupon step-down SLB hybrid and likely investor push-back for structures with large step-downs, we believe that the step-down should apply for a limited period, e.g. 1-2 years, hence SPTs observed 1-2 years before the first call date.

The result: Investors would become more comfortable with a coupon step-down SLB hybrid structure, and KPIs would be accepted as being meaningful, the period of the step-down application could increase.

Illustrative structure

With these considerations in mind, we believe that a potential debut SLB hybrid structure could be, as shown in the following illustrative example – 2.000% NC7 with SPT observation in Year 6 and a 3-month par call (25bps step-down is only an illustration, the exact amount would depend on the market dynamics / investor feedback / strength of the KPI):

Source: NatWest

Conclusion for Issuers

  1. Consider which sustainability KPIs would be appropriate for a hybrid transaction
  2. Assess whether existing targets (publicly disclosed) for these KPIs would align will with the desired hybrid non-call period
  3. Ensure that the SLB framework contains adequate provisions for issuance of hybrid instruments
  4. Develop a careful investor engagement strategy to ensure a strong market reception to reach your desired commercial outcome

In the next article in this series, we will delve deeper into the likely investor base and considerations around investor demand for an SLB hybrid and what KPIs are viewed as meaningful.

If you have any queries about anything discussed in this article, please reach out to one of our authors:

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