Fixed Income Boutique

Second time lucky?


Last year we published a whitepaper detailing our thoughts on green bonds; in the paper, we discussed some of our concerns surrounding the use of proceeds and whether they deliver for fixed income investors on a risk-adjusted basis.

One of the examples we touch on is Repsol, the Spanish energy firm. In 2017 they issued the inaugural green bond from the oil and gas sector which attracted widespread criticism from the media and investors. To summarise, the purpose of the issue was to finance an upgrade to existing refining facilities in Spain and Portugal. Essentially this 'green' bond was to increase the lifespan of 'brown' assets, increasing their efficiency, increasing profitability, and in absolute terms increasing total emissions over the life of these assets. The controversial purpose of the issue resulted in the bond’s suspension from the major green bond indices but nonetheless still attracted significant investor demand with books more than 5x covered.

On Tuesday, they again tested the appetite of the ESG bond market, but this time in the form of a sustainability-linked bond (SLBs) following the release of their sustainability financing framework just last week, where they committed to becoming a net-zero emissions company by 2050. For anyone not familiar, SLBs are very different from green bonds in that proceeds can be used for general corporate purposes rather than a specific ring-fenced asset or project. These bonds are linked to one or more forward-looking key performance indicators (KPIs or sustainability targets). They are structured to include covenants that link the bond's coupon to an issuer fulfilling the terms of these specific KPIs. Importantly, they economically incentivise corporations to deliver on their promises.

In their latest transaction, Repsol (BBB rated) raised 1.25bn Euros across two senior unsecured tranches, an 8yr and 12yr. Initial price talks (IPTs) came at mid-swaps +70-75bps for the 8yr and mid-swaps +90bps for the 12yr before pricing at +50 and +70, respectively. The bonds contained KPIs linked to Repsol reducing the Carbon Intensity Indicator (g CO2e/MJ, CO2 emissions per unit of energy produced) by 12% by 2025 and 25% by 2030. If they fail to meet these targets, the coupon will increase by 25bps for the 8yr and 37.5bps for the 12yr.

It is hard to draw any immediate conclusion from this transaction other than Repsol's notable persistence to obtain sustainable financing. The deal was less than 2x oversubscribed (lower than the ESG bond average of 4.4x YTD [source: Santander]) across both tranches, and there was circa 5-7bps of new issue premium left in the transaction.  Given that ESG linked bonds tend to price very near fair value (+0.8bps [source: Santander]), or inside existing credit curves, the spread premium was a surprise. One would assume the weak market reception for this issue was due to idiosyncratic factors lingering from Repsol's last foray into the ESG bond market rather than any broader concerns surrounding the nature of these bonds. 
                                             
The SLB market still represents a very small portion of the wider ESG related bond market. A year ago, we expected the SLB market to gain momentum for two reasons. Firstly, they are favoured by many investors versus green bonds. Secondly, SLBs will open sustainable and cheaper funding opportunities for issuers – often SMEs – that so far have been unable to issue green, social, or sustainable bonds as they cannot identify eligible assets or projects. 

However, this transaction may mark a turn in the tide for SLBs. For instance, if oil and gas majors with their vast capital requirements wade into the SLB space, the SLB market could rapidly surpass the supply of green bonds. How the market would react to that possibility remains unclear, but, on the face of it, transition-like bonds certainly appear to be the more appropriate ESG bond of choice for the oil and gas sector. Financial incentivisation may be the stimulus needed to accelerate change in this industry.