Despite representing a relatively small proportion of sustainable bond issuance today, sustainability-linked bonds are rapidly becoming more popular. Xuan Sheng Ou Yong looks at these performance-linked securities and their advantages and disadvantages.
Climate action is high on everyone’s agenda, and as such, there is a lot of focus on green bonds. The Covid-19 pandemic has also shone a light on social bonds – securities designed to fund measures aimed at addressing social issues including the impact of the coronavirus. Sustainability bonds, those that include both green and social use of proceeds, are also in vogue.
There is, however, another member of this increasingly diverse club – sustainability-linked bonds (SLBs). What are they, and why is their popularity growing?
|Green bonds||Use of proceeds linked to environmental projects (e.g. renewable energy installations)|
|Social bonds||Use of proceeds linked to social projects|
|Sustainability bonds||Use of proceeds linked to the Sustainable Development Goals (SDGs)|
|Transition bonds||Use of proceeds linked to projects which are not generally considered sufficiently green, but still contribute to CO2 avoidance|
|Sustainability-linked bonds||Coupon payment is linked to the sustainability performance of the issuer (e.g. lower greenhouse gas emissions)|
|Environmental or social impact bonds||Coupon payment is linked to a specific impact objective (e.g. prison recidivism rate; flooding incidence)|
Source: BNP Paribas Asset Management, July 2021
Demand from investors for financial products with a sustainability theme has been reshaping capital markets. One of the consequences has been significant growth in the sustainable use of proceeds bonds and sustainability-linked bonds.
According to the Environmental Finance Bond Database, thematic bond issuance – incorporating green, social, sustainable and sustainability-linked bonds – passed USD 600 billion in 2020, nearly doubling 2019’s USD 326 billion. Furthermore, the amount of thematic bonds issued in Q1 2021 was double that of Q1 2020.
Specifically, SLBs look to be rapidly growing in popularity, with some estimates indicating that in the first five months of 2021, SLB sales increased by 7 000% (albeit from a small base).
With sustainable use of proceeds bonds, the proceeds are used exclusively to fund projects with environmental and/or social benefits.
In comparison, SLBs are usually issued as general obligation bonds with contractual links to the achievement of a sustainability target or targets by the issuer. Usually, an issuer agrees to pay a higher coupon to the investor if they fail to achieve a linked sustainability target.
Italian energy company Enel, for example, recently raised USD 3.96 billion through SLBs. Under the deal, if its GHG emissions exceed a certain level by a set deadline, the coupons increase by 25bp. UK retailer Tesco has issued a bond with payments contingent on improvements in emissions, renewable energy use and food waste.
Compared with green bonds, the issuer of a SLB can use the proceeds for general purposes and is not required to track the projects funded by the issuance. This provides the issuer the freedom to choose how it intends to achieve its sustainability targets.
An SLB allows issuers to demonstrate a commitment to sustainability, even if they don’t currently have dedicated green or social projects planned. An SLB focuses on a company’s future trajectory and the achievement of more sustainable outcomes.
Do SLB investors not benefit from higher coupons and thus a higher running yield if an issuer fails to meet sustainability targets? Yes, but this view can be shortsighted. If a firm fails to meet its targets, it could lead to reputation damage that may represent a greater credit risk for investors.
What about the relative opacity of SLBs? Since SLBs have no restrictions on how capital will be spent, investors do not have a clear idea of the impact they will have. Some investors will prefer use of proceeds sustainable bonds since they clearly support sustainable projects.
The flexible nature of SLBs can make them prone to the risk of greenwashing. For instance, some issuances have been tied to KPIs that are clearly readily achievable. Investors should thoroughly check the KPIs to ensure they are sufficiently ambitious.
In addition, since SLBs are relatively new, and internationally agreed principles do not prescribe any standardised metrics to be linked in SLBs, issuers may select metrics that are unique to their situation. This makes it difficult for external stakeholders to compare issuers and issuances.
The unpredictable nature of SLB coupons has not made them popular with some regulators. The European Banking Authority has said banks should not use SLBs to meet capital requirements. If sustainability targets are not met, banks would face redemptions or weakened credit ratings.
At the same time, the ECB, after previously not accepting SLBs as collateral, has started to do so, provided the coupons link to a performance target related to the EU’s taxonomy or the UN’s SDGs.
Surveys have indicated that around two thirds of financial advisers believe SLBs are most likely to meet the growing demand for ESG-linked fixed income assets. S&P Global Ratings anticipates the global issuance of sustainability-linked debt instruments to surpass USD 200 billion in 2021.
Despite the impressive recent growth, it is important to note that in May, SLB issuance was just 25% of that of green bonds. For SLBs to become leading investment products in the sustainable bond space, measures are needed to prevent greenwashing and ensure clarity on how capital is allocated. Standardisation of the KPIs to facilitate performance comparability across issuers is also key.
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