IIGCC issues new guidance on bondholder stewardship in labelled debt
New guidelines offer investors mechanisms for ramping up the pressure on bond issuers
Ever since a group of Swedish pension funds urged the World Bank to issue a green bond in 2008, sustainable debt’s popularity has risen amongst investors. In the first half of 2024, $5.1 tn of sustainable debt was issued according to Climate Bonds Initiative, a non-profit. These bonds provide investors with not only a financing mechanism through which they can invest in climate solutions but also an asset class through which capital markets further incentivise corporate decarbonisation.
Stewardship, for bondholders, is less straightforward than it is for their equity counterparts. Unlike the later, bondholders typically do not attend annual general meetings and lack the leverage of ownership and voting rights. Bondholder stewardship takes on other forms, either prior to an issuance or following it. Gauging and extending its effectiveness is a critical challenge for investors, as Chandra Gopinathan, a member of the IIGCC working group which drafted the paper emphasises: "There continues to be a need for clear accountability mechanisms in
fixed income. Bondholders do not
have voting rights and disclosure
requirements in prospectuses remain minimal and voluntary, both od which pose
challenges for effective engagement. The bondholder stewardship work focuses on connecting issuer level
climate commitments and transition strategy to a bond issuance and building the
accountability mechanisms for the
bond ecosystem, including investors, policy makers and regulators."
New guidance issued by the Institutional Investors Group on Climate Change (IIGCC), an investor coalition, explores the complex terrain of bondholder stewardship in labelled debt and recommends a way forward.
Labelled debt
Broadly speaking, sustainable debt falls under two categories. The first, Use-of-Proceeds (UoP) bonds raise capital for a specific project with a positive environmental impact. Green bonds, such as the one issued by the World Bank in 2008, fall into this bucket.
The second, are bonds linked to a sustainability-related performance metric. As the name suggests, sustainability-linked bonds (SLBs) are KPI-linked debt instruments. Both green bonds and SLBs are examples of labelled debt, which the IIGCC guidance focuses on.
Gopinathan acknowledges that in the case of labelled debt, investors already operate from a better starting point: “With labelled debt, there are frameworks in place that provide some guardrails around the links to corporate climate targets and use of proceeds albeit with some gaps. Unlabelled debt is largely unexplored on this front and constitutes a large percentage of debt issuance especially from high emissions sectors and companies. So, there is a lot of room for progress."
"We need much better transparency around what the proceeds
are being used for, be able to track these over time to assess the issuer’s use
of bond markets to fund the transition, reduce greenwashing and steward more
responsible allocation of bond investor capital" he adds.
Issuer over issuance
The IIGCC recommends an issuer over issuance approach to labelled debt. Context, the coalition reckons, matters more than the instrument:
“Understanding bondholder stewardship as an issuer focused activity, rather than issuance, can help extend engagement beyond individual issuance maturity dates, with a view to enhancing the focus on managing and mitigating long-term climate related financial risks”, says the guidance.
Bondholders have much to gain from a focus on the integrity of an issuer’s net zero strategy and how the bond relates to its attainment. For one, it could make stewardship across labelled and unlabelled debt more consistent. In addition, an issuer-centred risk assessment can help investors leverage multi-asset holdings across the company’s financing structure and make engagement more holistic in nature.
For green bonds in particular, the IIGCC’s recommended approach pushes the investor’s horizon beyond the specific project for which funds are being raised:
“Assessments of green bonds that primarily focus on the use of proceeds potentially risk isolating the assessment of the bond from the wider strategy of the company. This can lead to greenwashing”, the guidance warns.
The coupon step-up: a bondholder’s guide to escalation
A key lesson from the world of equity stewardship is that escalation strategies matter. Disincentivising negative corporate behaviour is almost as valuable as incentivising the positive kind.
In the past, equity investors have chosen divestment as a tool of last resort, when all else fails.
For holders of labelled bonds, escalation takes the form of post issuance coupon step-ups. SLBs tend to include a step-up of around 25 bps. However, a one-size-fits-all approach to coupon step-ups overlooks several factors such as the company’s scale or the degree of its underperformance.
Determining the appropriate step-up is a complex task. The fact that the appropriateness would vary by company makes it decidedly so.
“For investors, step-ups need to balance materiality and credit risk: large enough to incentivise the issuer to meet its targets and hedge against additional risks created by failure to do so, and not so material as to put undue pressure on the cashflow of the business”, the IIGGC says.
The guidance outlines possible solutions to improve materiality of coupon step-ups. For example, one approach considers the company’s outstanding SLBs and the extent to which KPIs to which these bonds are linked, overlap.
Another solution, recommended by the Anthropocene Fixed Income Institute is the “greenback SLB”. The expected pay-out of the step structure for such bonds is “at least one dollar (one percentage point) in absolute risk-discounted value, with an assumed 50% step probability”.
Consequently, this lowers the initial cost of capital for companies while significantly increasing the coupon step-up.
Labelled debt markets provide investors with not only a lucrative capital allocation opportunity but also an additional channel for engaging with issuers. As the popularity of such bonds reaches a record high amongst issuers and investors alike, the efficacy of bondholder stewardship seems set to become all the more pertinent.
