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?
| Bond type | Description |
| 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
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 am an expert in sustainable finance and environmental, social, and governance (ESG) investments, with a deep understanding of thematic bonds and sustainability-linked bonds (SLBs). My expertise is rooted in extensive research, analysis, and practical experience within the sustainable finance sector.
Now, let's delve into the concepts mentioned in the article:
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Thematic Bonds: Thematic bonds refer to financial products with a sustainability theme. They include various types of bonds, such as green bonds, social bonds, sustainable use of proceeds bonds, and sustainability-linked bonds.
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Green Bonds: These are bonds where the use of proceeds is specifically tied to environmental projects, such as renewable energy installations.
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Social Bonds: Social bonds allocate proceeds to fund social projects, addressing issues like healthcare, education, or pandemic response.
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Sustainability Bonds: These bonds link the use of proceeds to the achievement of Sustainable Development Goals (SDGs), encompassing both environmental and social objectives.
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Transition Bonds: Funds from transition bonds are directed to projects that contribute to carbon dioxide avoidance, even if they aren't strictly considered "green."
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Sustainability-Linked Bonds (SLBs): SLBs stand out as a unique category where coupon payments are tied to the sustainability performance of the issuer. They differ from other sustainable bonds in that they are general obligation bonds with contractual links to sustainability targets.
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Issuer Flexibility: Unlike green bonds, SLB issuers have the freedom to use proceeds for general purposes. The focus is on achieving sustainability targets rather than specific projects.
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Contractual Links: SLBs involve agreements where issuers pay higher coupons if they fail to achieve specified sustainability targets. For example, Enel's SLB increases coupons if greenhouse gas emissions exceed a set level.
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Benefits and Drawbacks of SLBs:
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Flexibility for Issuers: SLBs allow companies to showcase commitment to sustainability, even without dedicated green or social projects.
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Investor Perspective: While higher coupons may attract investors, failure to meet sustainability targets can lead to reputation damage, representing a significant credit risk.
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Opacity and Greenwashing Risk: The flexible nature of SLBs raises concerns about opacity and potential greenwashing. Investors may lack clarity on how capital will be spent, and ambitious Key Performance Indicators (KPIs) are essential to avoid greenwashing.
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Regulatory Landscape: Some regulators express concerns about the unpredictable nature of SLB coupons. The European Banking Authority discourages using SLBs to meet capital requirements.
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Future Outlook: Despite recent impressive growth, SLBs still represent a smaller market share compared to green bonds. Measures are needed to prevent greenwashing and ensure transparency in capital allocation. Standardization of KPIs is crucial for performance comparability.
In conclusion, the landscape of sustainable finance is evolving, with SLBs emerging as a dynamic instrument that aligns issuer incentives with sustainability goals, albeit with challenges that require careful consideration.
