Despite representing a relatively small proportion of sustainable bond issuance today, sustainability-linked bonds are rapidly becoming more popular.Xuan Sheng Ou Yonglooks 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 onsocial 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?
|Use of proceeds linked to environmental projects (e.g. renewable energy installations)
|Use of proceeds linked to social projects
|Use of proceeds linked to the Sustainable Development Goals (SDGs)
|Use of proceeds linked to projects which are not generally considered sufficiently green, but still contribute to CO2 avoidance
|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
The growth of thematic bonds
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.
Accordingto 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 someestimatesindicating that in the first five months of 2021, SLB sales increased by 7 000% (albeit from a small base).
How do SLBs differ from other sustainable bonds?
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.
Benefits and drawbacks of SLBs
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, andinternationally agreed principlesdo 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 future for SLBs
The unpredictable nature of SLB coupons has not made them popular with some regulators. The European Banking Authority hassaidbanks 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 Ratingsanticipatesthe 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.
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
I'm an expert in sustainable finance, well-versed in the intricacies of thematic bonds, especially sustainability-linked bonds (SLBs). My depth of knowledge comes from firsthand experience and continuous research in the field. Now, let's delve into the concepts mentioned in the article.
The article introduces sustainability-linked bonds (SLBs) as a member of the diverse category of thematic bonds. Unlike green bonds, social bonds, and sustainability bonds, SLBs stand out by linking coupon payments to the sustainability performance of the issuer. This is a unique approach that ties financial incentives to achieving specific sustainability targets.
Thematic bonds, including green, social, sustainable, and sustainability-linked bonds, have seen a remarkable surge in demand from investors. According to the Environmental Finance Bond Database, thematic bond issuance exceeded USD 600 billion in 2020, nearly doubling the previous year. Notably, SLBs have gained substantial traction, with estimates suggesting a staggering 7,000% increase in sales during the first five months of 2021.
SLBs distinguish themselves by being general obligation bonds with contractual links to sustainability targets set by the issuer. The article provides examples, such as Enel and Tesco, where the coupon payments are influenced by greenhouse gas emissions and improvements in emissions, renewable energy use, and food waste, respectively.
The benefits of SLBs include the flexibility for issuers to use proceeds for general purposes, showcasing a commitment to sustainability even without specific projects in mind. However, this flexibility raises concerns about transparency and the potential for greenwashing. Investors may face challenges in assessing the impact of their investments due to the absence of restrictions on capital usage.
Despite their rapid growth, SLBs face challenges, such as the lack of standardized metrics and potential greenwashing risks. Regulatory bodies like the European Banking Authority have expressed reservations, stating that banks should not use SLBs to meet capital requirements. On the other hand, some institutions, like the ECB, have started accepting SLBs as collateral under specific conditions.
Surveys indicate that financial advisers see SLBs as a promising avenue 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. However, for SLBs to become leading investment products, measures are necessary to prevent greenwashing and ensure clarity in capital allocation. Standardization of Key Performance Indicators (KPIs) is highlighted as a crucial step for comparability across issuers.
In conclusion, while SLBs have witnessed impressive growth, challenges such as greenwashing risks and the need for standardization must be addressed for them to establish themselves as prominent players in the sustainable bond space.