Linking finance to sustainable strategies
Arguably the most important sustainable finance innovation since the development of green bonds, sustainability-linked bonds have picked up notable traction in the year since the launch of the Sustainability-Linked Bond Principles. But while the instrument provides the holistic issuer-level engagement that many investors are seeking, in contrast to use of proceeds bonds, questions remain over both the credibility of KPIs and applicability to financial and sovereign credits.
In the corporate realm, sustainability-linked bonds (SLBs) are going from strength to strength. Already a broad range of industrial sectors — from pulp and paper, steel and oil and gas to luxury goods, retail and even private equity — have seen transactions. These have been sold in a range of currencies that includes sterling, yen, Norwegian kroner and Swedish kronor besides euros and US dollars.
Moreover, SLBs have emerged across the capital structure, with several deeply subordinated corporate hybrids already sold, and across the credit spectrum. High yield and unrated issuers constitute as much as 35% of volume to date, according to Moody’s ESG Solutions.
Innovation has also brought the first SLB with a dedicated green use of proceeds (see accompanying Verbund interview).
In addition, flows from emerging markets have been significant. Brazil has been a particularly fertile source of issuers. At around 25%, EM names constitute a notably higher proportion of total SLB volume than of total green bond volume, for example.
Overall, sales so far in 2021 stand at around $10bn, according to Morgan Stanley data. This compares with under $5bn across all of 2020.
“The growth of the SLB market reflects the increasing recognition that financing of sustainable activities — whether they are green, social or otherwise — should have a clear link to an entity’s overarching ESG objectives or performance,” says Rahul Ghosh, managing director for ESG outreach and research at Moody’s ESG Solutions. “We’re seeing that concept take root in the use-of-proceeds market as well, but the SLB structure takes the idea a step further. Entities can embed their public sustainability commitments into their debt capital strategies, which is a really important and exciting development.”
This also answers investors’ increasing appetite for broad engagement with issuers rather than the project level access that use of proceeds structures provide. “SLB structures fit very well with investors that want to look at companies holistically, rather than having to scrutinise case by case use of proceeds,” says Alexander Menounos, managing director, head of EMEA DCM and global co-head of IG syndicate at Morgan Stanley. “The feedback on these instruments is highly supportive.”
SLBs “open the door to a much broader suite of sectors and issuers that can use debt financing to show and commit to their sustainability credentials”, Ghosh adds.
The product offers potential to highlight issuers’ overall ESG strategy. “It is very attractive from that perspective — a great platform for management to really reflect on the strategy and the commitments they make, and communicate that to the capital markets,” comments Maxime Stevignon, head of fixed income capital markets for France, Belux and Switzerland at Morgan Stanley.
“When we think about SLBs we typically think about decarbonisation, but it goes far beyond that. ESG strategy is also about social commitments and about good governance. Ultimately an SLB should be a driver for the three legs of ESG.”
Although volumes remain relatively small, the resulting diversification of issuers is striking. “We’ve seen companies from a variety of sectors, including consumer staples, transport and logistics, construction, paper and pulp, healthcare and financial sectors,” says Ghosh.
Addressing the need to transition entire businesses is a merit of SLBs over project-level use of proceeds bonds, Stevignon judges.
Ghosh argues that SLBs provide institutional investors with a wider spectrum of opportunities to finance, support and engage with companies’ efforts to transition to more sustainable business models.
In turn, the product’s diversity is drawing demand from investors because of its intrinsic mitigation of diversification risk in ESG bond portfolios, which are typified by heavy sector, geographic and credit quality. “We think that strong investor appetite for this kind of paper is going to be an engine of growth,” Ghosh says.
The European Central Bank (ECB)’s new ability and willingness to buy SLBs since the start of 2021 is particularly significant. “That is a real game-changer and will spur significant additional issuance,” says Menounos. “It’s not just potential incremental demand. It’s a vote of confidence in the product.”
A further important factor is efficiency. “The ongoing resource commitment in monitoring multiple investments or instruments is cumbersome and much less efficient than monitoring the issuer in an SLB format. That development is key for standardisation and to facilitate significant growth in volume,” he believes.
At the same time, SLBs address the capacity problem that companies in many sectors face over use of proceeds structures. They simply lack the eligible assets to finance through green or social bonds. “Not every sector will have solar plants as core to their operations, for instance. Yes, you can look at green activities that support your operations — maybe an energy-efficient project for one of your buildings. But it may not be core to your business,” Stevignon says.
In contrast, the SLB model accommodates companies that are not green or social pure plays. “They are still able to demonstrate their commitment to moving towards a lower carbon or more resilient model while retaining the flexibility that general corporate purpose allows,” notes Ghosh.
One key question over SLBs is the credibility of the targets and KPIs that companies embed in their bonds. “An important driver of critical mass will be issuers’ ability to really deliver beyond a business-as-usual pathway on sustainability,” Ghosh says.
Moody’s ESG Solutions identifies interim goals, historical KPI performance, science-based criteria (particularly for GHG emissions-related targets) and limited reliance on offsets, plus clear transparency and ambition on scope and coverage, as critical elements.
“Robust commitments in these areas can strengthen the credibility of targets,” believes Ghosh, who expects best practice to emerge “pretty quickly”. He cites the two-thirds of 43 SLBs in a recent Moody’s ESG Solutions study that provide three-year prior trend data for their KPIs as an example, whereas only eight reference Scope 3 emissions and only 10 directly reference science-based targets.
Some question the environmental focus of many SLB KPIs to date. This tendency may be exacerbated by the role of the ECB which, for now at least, can only purchase the product when it features exclusively environmental KPIs. This is affecting KPI selection by eligible issuers (eurozone companies and eurozone entities of companies from outside the currency bloc, such as Tesco of the UK). It may serve as a deterrent to the inclusion of social KPIs, which are in greater focus in the US.
Although assessment of the ambition of environmental KPIs is aided by guidance from Science-Based Target Initiative and other bodies, investor demand exists for non-environmental KPIs too, reports Cristina Lacaci, head of ESG structuring for global capital markets at Morgan Stanley.
“Investors are open to other KPIs and we have already seen several bonds with water conservation, waste reduction or diversity KPIs. Several investors have specifically mentioned that they would like to see more diversity KPIs,” she says.
Despite the ECB, broader KPI sets appear to be the direction of travel. “Over time, we will increasingly see frameworks with several KPIs to address companies’ various priorities,” Lacaci anticipates. (See accompanying Diversity chapter for further discussion.)
As the product matures, greater differentiation among SLBs of different tenors and credit quality is also likely. Currently the product’s structure typically defaults to a 25bp step-up in the event of issuers failing to hit KPIs, regardless of other factors.
“This reflects the relatively immature market. Over time we expect the financial features of SLBs to become more precise,” Ghosh says.
This raises the question of interplay between KPIs and credit quality — particularly the possibility that missing targets could indicate increased operational, financial and reputational risk. In turn, that could raise issuers’ cost of capital.
“Over time a failure to hit targets could constrain an issuer’s ability to raise additional ESG financing and have material financial implications above and beyond the 25bp. As that differentiation becomes more apparent in the market, you’ll start to see more variability ex-ante in some of the pricing of the structures,” he anticipates.
“The fact that the Commission will work on other bond labels such as transition or sustainability-linked instruments is a positive development,” says Lacaci.
Conflict of interest?
Some have charged that SLBs involve a conflict of interest, since investors are paid more if issuers fall short of their KPIs. But Ghosh dismisses these concerns. “Investors aren’t looking for issues to fail in pursuit of these objectives,” he affirms.
Rather, he anticipates that indications that issuers are not on course to hit targets will lead to increased engagement with investors. Consistent failures are more likely to lead to bondholders selling out of SLBs than holding on for additional coupon.
This makes the exhaustiveness and timeliness of post-issuance communication a critical element of the market’s future development. “Timely reporting will ultimately give investors the information they need to understand where an issuer stands on meeting the selected KPIs,” Ghosh notes, pointing to the need for post-issuance assurance on indicators and targets, as well as annual disclosures.
Perceived failures over reporting are likely to be looked upon “particularly unfavourably” by bondholders, he judges.
Despite banks’ growing issuance of ESG debt, they still face significant challenges in offering SLBs. This is because the MREL (minimum requirements for own funds and eligible liabilities) regime introduced by the Financial Stability Board as part of the concept of bail-in after the 2008 global financial crisis prohibits step-ups and credit-sensitive features.
Even if banks were to adopt the step-down variation which SLBs have very occasionally employed, they would still not circumvent the credit sensitivity prohibition. “The core of the question is whether meeting a KPI is something that reflects on your credit standing as an issuer,” believes Charles-Antoine Dozin, head of capital structuring at Morgan Stanley. “It’s difficult to make the case that the coupon step-up resulting from not being able to deliver on your ESG commitment is separate from your credit standing as an issuer. This is why the concept should be clarified.”
As a result, very few European banks that do not require their debt to achieve MREL-eligibility could be candidate issuers without a change to the ‘level one’ MREL text, according to Dozin. One of these is Berlin Hyp, the only bank to issue an SLB to date.
Moreover, unlike banks’ use-of-proceeds bonds, the European Banking Authority (EBA) has made no recommendations over issuing SLBs.
“Until we resolve the disconnect between the MREL rules and typical SLB structures I think activity in that space will remain subdued,” Dozin concludes.
Could sovereign borrowers begin embedding their Paris Agreement commitments in SLBs? A lively debate over this possibility continues, but no issuer has yet taken the decisive step. Even so, analysts and bankers see a case for a sovereign version of the product.
“We are seeing an increasing number of governments not just put out net zero targets up to 2050 but making increasing steps to have clear interim targets as well. And so this structure could make sense,” Ghosh says.
“SLBs are complementary to green, social and sustainable use-of-proceeds bonds. It’s an instrument that the market is exploring,” says Ana Colazo, head of sustainable finance for the UK & Nordics at V.E, part of Moody’s ESG Solutions. “Investors expect some sovereign issuers to come to market with inaugural SLB issues either in H2 2021 or 2022.”
The prospect of governments making commitments that future administrations would also have to honour or face financial penalties that taxpayers would have to fund may be off-putting to some sovereigns — even though they are likely to have already made public commitments to Paris and net zero.
“If you’re targeting eight or 10 year KPIs, it doesn’t really matter about changes in political environment — issuers will have quite a significant economic liability and incentive to reach the targets,” says Dan Shane, managing director and head of EMEA investment grade syndicate at Morgan Stanley.
Ghosh doubts that political sensitivity over potential failure to hit targets will deter sovereigns from SLBs. “The collective ambition that we’re seeing right now and the need to translate the Paris Agreement into clear concrete, tangible policies means that governments are increasingly going to have to show how they are meeting targets on a five and 10 year basis, rather than just out to 2050.”
Accordingly, failure to hit targets would be highly visible to civil society — regardless of whether that sovereign has issued SLBs.
The recency of the product’s take-off may also be a factor. “It’s a relatively new instrument, sovereigns just haven’t had a chance to really consider it,” believes Shane.
Even so, he regards sovereign SLBs as “probably quite compelling” for investors and believes the product will migrate to the sovereign realm in time. “That’s what investors want to see.” GC