September 13, 2023
Go with the flow, not just the stock: Sustainability-linked bonds and public debt dynamics
Sustainability-linked bonds (SLBs) and debt-for-nature swaps (DnS) are dominating the discourse on how to tackle the climate, nature and sovereign debt crises.
Both are seen as viable solutions for incorporating climate and nature commitments into sovereign financing arrangements. Yet if you spend enough time in these discussions, a subtle but crucial distinction emerges in how they are positioned to issuers, investors, and other stakeholders.
One argument suggests that where DnS transactions can reduce a country’s public debt burden or keep it level, SLBs constitute new borrowing which increases headline debt stocks. Therefore, asking governments to issue SLBs in the context of a worsening sovereign debt crisis in emerging and development economies (EMDEs) will exacerbate the crisis.
The flawed reasoning behind this argument undermines the case for SLBs among those able to catalyse this emerging asset class.
SLBs are no silver bullet, and so far, only two sovereigns have issued SLBs — Chile and Uruguay. The pipeline of offerings remains meager despite more than a year and half since the first proof of concept in early 2022.
There are significant challenges for capacity-constrained issuers to implement data and governance requirements of SLB transactions and the materiality of the incentives for achieving the embedded sustainability targets is another shortcoming.
And yet, they have genuine potential to narrow the prodigious gap in climate and nature financing. For this reason alone, the narrative that SLBs are detrimental to the cause because they add to debt stocks must be contested.
This first blog in a series on SLBs develops two main counterarguments to current misconceptions, namely (1) that SLBs are instruments of sound liability management, and (2) that debt stock matters less than debt dynamics from the standpoint of debt sustainability.
SLBs as liability management tools
Unlike use-of-proceeds bonds that stipulate proceeds must be earmarked for specific projects (eg. green bonds, blue bonds)– SLBs allow for the general use of proceeds.’ This provision includes refinancing debt coming due or buying back bonds in the secondary market – in effect, a conversion of conventional “vanilla” for sustainability-linked debt.
Liability management operations whereby sovereigns roll over rather than pay down maturing obligations is a standard debt management strategy. Governments with budget deficits generally lack the liquidity to cover large principal repayments at any given time.
Indeed, both Chile and Uruguay used the proceeds of their SLB issuance to buy back outstanding global bonds as well as general budgetary needs. Their headline debt stocks were not projected to rise following the SLB issuance last year according to the latest IMF World Economic Outlook.
Figure 1: Chile and Uruguay debt trajectory pre-/post-SLB issuance
General Government Debt, % of GDP
SLBs in public debt dynamics
The notion that SLBs are additive to debt burdens is misleading because the stock of debt is not the main concept to focus on from a debt sustainability standpoint. What matters is the change in debt stocks in the future.
Before examining how SLBs feed into such debt dynamics, you can read this detour into the weeds of sovereign debt math.
SLBs can play a decisive role in restoring debt sustainability of EMDE sovereigns. By appealing to a deeper and broader pool of capital that is oriented towards environmental, social, and governance (ESG) objectives, they can command a lower interest rate compared to conventional bonds.
Admittedly, the so-called “greenium” on the Uruguay and Chilean SLBs were too small to make a meaningful difference for their debt dynamics. However, because both are ‘BBB’-rated issuers, they arguably do not represent the greenium potential for sovereigns on the lower rungs of the credit scale.
Investors may be more inclined to reward lower-rated issuers of SLBs with bigger discounts in borrowing costs, provided the sustainability targets embedded in the bonds are both ambitious and material (more on this shortly). This is of course purely conjecture in the absence of such issuances to date.
The pricing advantage of SLBs could also come from credit enhancements provided by multilateral development banks (MDBs) and development finance institutions (DFIs). These improve the credit rating of the bonds by guaranteeing all or some of the debt-service payments of the underlying instrument.
This “rating uplift” enables these issuers to attract risk-averse investors who might otherwise eschew “speculative” grade bonds. The credit enhancement providers in turn may be more inclined to guarantee SLBs rather than vanilla bonds because of the embedded sustainability targets, performance tracking processes, and financial incentives.
And by crowding-in private investors, the MDBs and DFIs can mobilize substantially larger sums of funding compared to outright lending (in the order of $1.5 of capital mobilized via guarantees for every $1 of lending, according to recent estimates).
Even without credit enhancement or a “greenium”, SLBs have other benefits in terms of debt dynamics that may justify higher stocks in the short term.
First, if SLBs incorporate targets that map directly to material credit weaknesses in a sovereign’s risk profile, then achieving those targets should result in an improvement in creditworthiness and by extension a reduction in credit risk premia. All else being equal, this should feed through to an ex-post improvement in the r-g differential.
Furthermore, if the SLBs encourage actions by the government to contain climate-related contingent liabilities — meaning smaller catastrophe-related outlays such as disaster relief and reconstruction — then that will be reflected in smaller deficits/larger surpluses. The net effect again is to improve the debt dynamics.
Second, since SLBs require a high degree of inter-ministerial coordination as well as robust data infrastructure to compile and feed the key performance indicators (KPIs) for the life of the bonds, they can also benefit public financial management and macroeconomic policy making more broadly.
In other words, they can create the impetus for greater policy alignment across government agencies whether in service of sustainability targets or other objectives. To the extent that these positive spillovers improve policy credibility and perceived ‘willingness to pay’, then the issuers should receive some reward upfront in terms of pricing and ratings — call it the “credibility premium”.
Our illustrative example of the Dominican Republic consolidates these points. Read it here.
Reframing the narrative
A narrow reading of sovereign risk that focuses excessively on debt stock ignores the multiple pathways through which SLBs can promote debt sustainability.
Practitioners and observers need to take a holistic view centered on debt sustainability analysis. This is more than just an academic debate. The trade-off faced by debt managers between vanilla bonds and SLBs in terms of the additional transaction costs entailed by the latter are a decisive factor in whether the sovereign SLB market takes off.
Omitting these broader considerations needlessly skews that calculus in favor of vanilla instruments.
The misconception of SLBs and debt dynamics may also discourage MDBs and DFIs from granting credit enhancements for SLBs. Here the trade-offs between issuing guarantees versus loans is equally fraught, notwithstanding the higher mobilisation rates cited above.
There are only a handful of examples where they have issued guarantees directly for sovereign bonds (those applied to DnS technically don’t apply since the guarantees are made out to a special purpose vehicle sitting between the sovereign and the guarantor). The partial risk guarantee (PRG) provided to Ghana in 2016 for a vanilla offering is a recent one.
Whether MDBs and DFIs will guarantee SLBs going forward is an open question in light of the controversy surrounding the Ghana PRG and the negative publicity it has brought on. While their hesitancy to underwrite sovereign bonds has many reasons besides reputational risk, for certain institutions it is simply an explicit restriction on transactions that increase public debt stocks.
This seems misguided in this case given that SLBs tick the right boxes of promoting debt sustainability, embedding policy conditionality, and addressing climate and nature risks.
In any event, so long as governments are running deficits and outstanding debts are coming due, they will issue fresh debt. From a public financial management standpoint, there are compelling reasons for this debt to be sustainability linked.