ESG Covenants in High Yield

TwentyFour Blog
While we do not expect 2021 to provide the levels of corporate issuance that 2020 did, one area of the market that we feel confident will continue to provide healthy levels of issuance growth is the sustainable bond market. Indeed, last month saw ESG-labelled debt issuance of $77bn, 3.5 times higher than January 2020, and $7bn more than the entirety of the first quarter of 2020’s issuance of ESG debt.  
 
The growth in ESG debt has, as you would think, been driven by Investment Grade issuers, particularly SSAs (Sovereign, Supranational and Agencies), given the role that they play in funding environmental and social initiatives. 
 
We have however seen these bonds playing an increasingly important role in the high yield market. Klockner Pentaplast, a PE owned German packaging company, announced the refinancing of their capital structure last week. As part of the transaction the company are issuing a €1.175bn equivalent Term Loan package which includes an ESG-linked margin ratchet (as well as a leverage linked one). To be clear, the loan is not being marketed as an ESG/Sustainable loan, but the margin will decrease (or increase) depending on whether the company achieves three ESG targets by 2023; a 38% reduction in Scope 1 & 2 emissions, at least 26% of their products produced with recycled materials and that women will make up at least 27% of their management team. The performance targets will be tested annually and verified by a 3rd party, and if they reach their targets by 2023 they will see a 2.5bps reduction in the interest they will pay on their loan (or a similar increase if they miss their targets). 
 
While we do not view these targets as particularly ambitious (the leverage ratchet by comparison will see them reduce the TL margin by 25bps if they de-lever the balance sheet by 0.5x, up to a maximum of 1.5x vs initial senior secured net leverage), we view the introduction of ESG margin ratchets as becoming increasingly important to investors. 
 
Much like the coupon step-ups that were written in to the covenants of Investment Grade companies that were at risk of falling to high yield, we expect to see investors demanding compensation for a deterioration in ESG related factors, which can lead to a deterioration in credit quality. We would not be surprised to see this feature appear in high yield floating rate bonds next, with syndicate desks pitching ways to take advantage of the strong sector flows into ESG-related funds (annualised ESG fixed income fund growth was over 30% for 2020, outpacing the wider market by roughly 25%).
 
Ultimately, the fact that the Klockner deal is not marketed as a green loan but still includes ESG-related covenants is proof that ESG needs to be integrated into an investor’s credit work as a matter of course, something we have been arguing for years. The margin ratchet in the deal is small relative to the leverage one, but we would not be surprised to see that increase in the coming years, so the cost to the investor for ESG-related underperformance is only going to increase.