Sustainability-linked bonds or SLBs are currently issued by corporations. According to the terms of the bonds, the issuer pledges to meet specific sustainability targets within a certain timeframe. If it fails to hit these targets, the issuer automatically grants a coupon step-up to bondholders. These bonds, first issued in 2019, are increasingly popular at a time of heightened ESG awareness within the investment community.
A concrete example would be the first SLB ever, launched by Enel, an Italian utility. The issue was linked to the following goal: to have a renewables-installed base of at least 55% of its power generation capacity by 2021, up from around 46% in mid-2019. If Enel failed to reach this goal, its 2.06% 2024 SLB would offer a coupon increase of 25 basis points per year for the remainder of the bond’s lifetime.
One key point: SLB issuers have full flexibility on the use of proceeds, as opposed to issuers of green and social bonds where proceeds must be used for specific environmental or social projects.
The ESG challenges ahead are of such magnitude that relying solely on use-of-proceeds bonds is insufficient. Investments from all types of issuers will be required to successfully make the transition to a low carbon and inclusive society; yet, some corporations are currently unable to issue green bonds for a variety of reasons, such as the profile of their business activity or balance sheet size.
Investments from all types of issuers will be required to successfully make the transition to a low carbon and inclusive society.
The SLB concept is not perfect. As is the case for any ESG product, the risk of greenwashing is present. Since use of proceeds is not tied to a project, it can also be difficult to measure the direct impact of SLBs. Finally, there is some kind of moral hazard, as investors get rewarded if the issuer fails to meet its sustainability targets. But, all in all, the SLB concept embodies the saying: “put your money where your mouth is”.
As always, carrying out in-depth research is essential to establish the sustainability profile of an issuer and its ESG goals. Verifying compliance with the SLB Principles, which are guidelines published by the International Capital Market Association (ICMA) in 2020, and looking at Second Party Opinions, when available, is a good start. At DPAM, we work closely with our Socially Responsible Investment team that has built robust expertise over 20 years. Key Performance Indicators (KPI) that are material to specific sectors have been developed in-house. Aside from financial aspects, one must have a comprehensive view of the issuer’s sustainability track record, the SLB’s specific, preferably science-based goals and the criteria to be applied to assess completion.
Incidentally, SLBs tend to have environmental rather than social objectives so far. We believe that this is due to the abundance of expertise, science, and policies in the environmental and climate fields. Corporations are increasingly developing net-zero business strategies, while the EU Taxonomy provides ample and detailed information on environment-friendly business practices. This facilitates the development of relevant, specific, material and verifiable environmental KPIs and therefore the launch of environment-focused SLBs. More efforts are needed to attain a similar level of sophistication in expertise on criteria, practices, etc., for social goals.
Corporations are increasingly developing net-zero business strategies, while the EU Taxonomy provides ample and detailed information on environment-friendly business practices.
The SLB market really took off over summer 2020 once the ICMA issued its first guidelines, the building blocks of standardised SLB frameworks that can facilitate issuance and investments. That is also when the ECB decided to include select environmental SLBs in its asset purchase programs.
While year-on-year growth of SLB issuance has been impressive, SLBs still represent less than 2% of the USD2 trillion ESG debt market. Green bonds take the lion’s share with more than 70%. In May 2021, over 20% of ESG debt issuance was launched under the SLB format. We believe that green bonds and SLBs will continue to enjoy strong growth rates.
They are complementary instruments. Their distinct features can meet different investors’ needs. Green bonds probably appeal more to investors looking for a direct impact via green projects, whereas SLBs are more about greening finance. While greater standardisation, transparency and reliance on science-based external validation practices are still needed, the growth outlook for SLBs is tremendous. Over the next 12 months, we could very well see SLB issuance increase by USD100 billion. The pool of ESG-focused debt is growing and diversifying, creating new opportunities to build wealth responsibly. We are convinced that, with active management based on specialist ESG and credit research, investing in SLBs can offer numerous advantages: attractive financial potential, wider credit risk diversification, an opportunity to green up your portfolio and also incentivise corporations to achieve real and significant ESG progress.