The growing market of sustainability linked bonds

As governments have now clear targets in place, to amongst others reduce emissions, over the past two years we’ve seen a growing market for sustainability-linked bonds (SLB). This is clearly in response to as said the urgent need to fund global and environmental challenges. Moreover, as time progresses, investors’ changing mentality of sustainable investing seems to be a focal point in investment portfolios.

First and foremost it is important to make a clear distinction between SLB and green or sustainable bonds. The latter are linked to a particular project, with the use of proceeds being clearly earmarked to a project that will ultimately emerge as a green or sustainable project. A practical example would be a company funding its windfarm project to generate energy for plants as opposed to the currently used traditional energy. On the contrary, SLBs are issued for general corporate fundraising with no restrictions on the use of proceeds and these can also be used for non-green projects. However, these projects would include forward-looking sustainability objectives.

The most interesting bit of these type of investments is that SLB have environmental, social and governance (ESG) related key performance indicators (KPIs) in their structure. This implies that if a company has raised capital through a SLB but throughout the tenor of the bond it fails to meet the pre-agreed KPIs, the issuer would need to pay a penalty. A very popular structure which we are seeing in newly issued SLBs, is the step-up coupon clause. This implies that if the issuer fails to meet the pre-agreed KPIs it will have to make additional payments to the bondholders, i.e. financing costs for the issuer would increase. Usually the step-up increments are 25bps per annum, although lately we have seen issuers also holding step-ups of 50bps and 75bps. The beauty of step-up clauses is that it disciplines issuers to comply with their KPIs as if they fail to do so the cost to service their debt will increase. Thus this pressures mostly management to ensure that sustainable ways of operating are being achieved.

As previous pointed out, SLBs are not always suitable for dedicated ESG-focused investment portfolios. Usually SLBs can be seen as the bridge between traditional corporate bonds and ESG bond issuance. In reality they are more flexible and dynamic than green and social bonds, however have a clear drive of achieving ESG long-term goals.

Moving forward, we believe that from an investors perspective SLBs are a good option in the transition towards the greener and more sustainable world, while from an issuers perspective the embedded ESG long term goals gives the company the ability to possible financing at a lower rate-however with strict discipline throughout the tenor of the bond due to the embedded step-up coupon clauses. Undoubtedly going forward we will continue to see a growing market in this area.