September 13, 2023
How sustainability-linked bonds can improve sovereign credit ratings: an illustrative example
Issuing sustainability-linked Bonds (SLBs) can address several credit rating weaknesses by reducing the cost of borrowing, insulating governments’ climate and nature policies and commitments from the political cycle, and providing long term credibility.
Take the case of the Dominican Republic (DR), which is rated ‘BB-’ by Fitch Ratings. In their latest assessment from December 2022, they argue that Dominican Republic ratings “are constrained by fiscal weaknesses including a high interest burden and subsidization of a loss-making electricity sector, improved but still relatively narrow external liquidity buffers, lingering weaknesses in the macroeconomic policy framework, and heavy sovereign reliance on external bond market financing that could pose a vulnerability amid tighter global conditions.”
Let’s consider how an SLB could address each of these weaknesses.
Figure: Dominican Republic versus rating peers on select fiscal metrics
Dec. 2022 review
A reduction in the cost of borrowing — whether due to greenium, credit enhancement, credibility premium, or reduction in credit risk premia due to target achievement — tackles DR’s large interest bill, which at around 20% of fiscal revenues is one of the highest levels in the 'BB' category. It is an indicator with considerable weight in Fitch’s sovereign rating model, and hence an improvement directly feeds through to the quantitative component of their rating.
Next, Fitch deducts one notch in its ‘qualitative overlay’ for the “vulnerability posed by a heavily subsidized electricity sector”. This reflects not only the fiscal drain from direct transfers to cover operating losses of electricity distributors, but also a heavy reliance on imported hydrocarbons in the island’s energy mix and therefore exposure to energy price shocks.
It also stems from the failure to enact energy sector reform, notably the “Electricity Pact” launched in 2021, which has eroded policy credibility.
An SLB that embeds an energy transition target like the one adopted by Chile in 2022 would signal to the rating agencies the government’s firm commitment to implement the Pact, given the financial and reputational penalties for not doing so. It would insulate the Pact from the political cycle, one reason cited by the Agency for why it questions the commitment to reform.
The “narrow external liquidity buffers” and “heavy sovereign reliance on external bond market financing” are important in Fitch’s view because a large share of its public debt is denominated in foreign currency. This exposes the sovereign to sudden capital outflows, especially in the current context of tightening credit market conditions.
ESG-oriented investors are arguably more “patient” than their vanilla counterparts given a greater focus on performance against sustainability targets rather than short-term risk-return calculations. They are less likely to flee for the exits in times of market turmoil and consequently require smaller buffers to protect against capital flight.
Finally, in citing “lingering weaknesses in the macroeconomic policy framework”, Fitch highlights the inconsistency of fiscal policy with debt sustainability as well as challenges with anchoring market confidence and borrowing costs.
A SLB underpinned by a solid data architecture would support efforts to align policies with climate commitments and debt sustainability frameworks. Investor confidence meanwhile is promoted via the credibility mechanisms baked into the instruments — the coupon step-ups/-downs, the increased scrutiny by financial markets, and the reputational costs of missing targets.
SLBs are instruments of sound liability management and provide multiple pathways to address debt sustainability, further explored in our blog.