ESG Focus | Sep 15 2021
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Big End Of Town Eyes SLBs
Major corporations are using sustainability-linked bonds to fill their coffers to fund their green transitions, which is set to kick off in earnest in 2022.
– A servant to many masters
– Issuers frameworks paramount to investors
– Materiality and pricing
Sustainability-linked bonds (SLBs) are one of the more innovative products to hit ESG markets and are aimed at the big end of town.
SLBs are an odd bird in the fixed-income world in that they can carry a floating rate, via a step coupon, rather than the traditional fixed rate.
One of the main reasons for this state of affairs is that SLBs were developed, in part, to incentivise the transition with penalties.
This means SLBs fall under both the transition finance (TF) and sustainability-linked finance (SLF) umbrellas.
Given the likely scale and impact of SLBs in transition finance, we will address that aspect in a separate article.
We will also examine social impact bonds and development impact bonds (often both SLBs) in a separate article on impact investing.
This article is divided into two halves and examines the broader applications and challenges of SLBs.
The first half examines the lay of the land, dealing with issues of materiality and covers some of the ground mentioned in our introductory article on sustainability-linked finance (see link below).
The second half examines the pros, cons and pitfalls of the market; its challenges and future; and early Australian issuance.
The new kid on the block
Sustainability-linked bonds (SLBs) only recently hit the market but issuance is expected to rocket as borrowers avail themselves of the cheap covid-19 funds flooding the world, filling their coffers to fund the green transition which starts in earnest in 2022.
Morgan Stanley’s report Sustainability-Linked Bonds: Materiality Is The Missing Link estimates the total SLBs issued since the market’s inception in 2019 to be US$57.7bn as of June 30, 2021, with 2021 issuance making up for than 75% of the total.
SLB turnover rose roughly 185% in the month of June alone and Morgan Stanley expects another $30bn will be issued by year-end, and another US$200bn within a few years.
This compares with the vanilla bond market’s US$3.8trn a year pre-covid (now at US$2.8trn – a figure that could continue to face erosion as ESG markets gain traction).
The first SLB was issued by Italy’s ENEL (one of the world’s largest energy companies) in 2019.
While SLBs are targeted squarely at the big end of town, smaller players that struggle in vanilla markets are likely to benefit from excess demand in the market’s early phases.
The SLB market is well diversified sectorally and is dominated by financials, utilities and REITS, all of which account for one third of total issuance; after SSAs (sovereign, supranationals and agencies), which represent more than half of issuance.
About 55% of SLBs issued to date are from private companies. When traced to the ultimate parent, that figure tops out at 15%.
The European Central Bank (ECB) announced it would buy SLBs at the start of 2021, which should further fire demand.
A servant to many masters
SLBs were designed to compensate for shortcomings in the green, social and sustainable (GSS) use-of-proceeds (UoP) markets in supplying transition finance and broader sustainability funding.
GSS activity was largely confined to green infrastructure projects, given green assets are easier to ring-fence than social and sustainability assets.
This in turn meant issuance in social and sustainability UoP markets suffered liquidity constraints.
SLBs have a broader application than UoP bonds and can be used for any general corporate purpose, any sector, and can be directed to either social or green endeavours.
SLBs permit this unrestricted use-of-proceeds for general purposes on the proviso a good percentage of funds are allocated to pre-specified sustainability initiatives that align with the United Nations Sustainable Development Goals (SDGs).
SLB projects can include: transitioning (reducing the carbon intensity of emissions and the broader business); water management (mainly reducing water withdrawal intensity); diversity; circularity; health; housing; infrastructure; industrial waste reduction; plastic-waste reduction; petroleum derivatives reduction; education; diversity; board diversity; and inclusion (ethnic diversity as a percentage of the workforce) – just to name a few.
SLBs carry penalties for failure to meet agreed sustainability measures such as step-down and step-up coupons – a typical carrot-and-stick incentive (see our previous article on sustainability-linked penalties in the link below).
The penalties are designed to encourage borrowers to meet targets and, in part, to compensate investors for lower transparency, as qualifying projects are not easily ring-fenceable.
The system is also designed to attract more borrowers and boost liquidity in ESG markets, to enrol the rest of the world in the sustainability drive.
SLBs also help entities embed their public sustainability commitments into their debt capital strategies.
Once the market matures, SLBs are forecast to offer greater flexibility, comparability/fungibility and accountability compared to UoP ESG bonds.
SLBs are particularly useful for transition financing given they incorporate measurable, forward-looking key performance indicators (KPIs) and sustainable performance targets (SPTs) into the structural and/or financial aspects of the bonds based on a standardized benchmark of carbon intensity.
Regulation and frameworks
The International Capital Markets Association (ICMA) published the sustainability-linked bond principles in June 2020, sparking a flurry of issuance.
These voluntary guidelines highlight five core components:
– selection of KPIs;
– calibration of sustainability performance targets (SPTs);
– bond characteristics;
– reporting; and
– verification.
The selected KPIs should be highly relevant to the issuer’s core business strategy and core sustainability challenges. They must be measurable, externally verifiable and benchmarkable.
They need to be under management’s influence, consistently quantifiable, and able to be verified by an independent third party.
Investors are likely to favour borrowers with frameworks that align to ICMA’s principles, forcing the system into self-regulation.
Borrowers are expected to provide:
– up-to-date information on KPI and SPT performance based on meaningful baselines;
– inclusion of a verification assurance report relative to the SPTs (the report should outline the borrower’s performance against the SPT and the impact and timing of SPT on the bond’s financial and/or structural characteristics); and
– any information enabling investors to monitor the level of ambition of the SPTs, such as a sustainability strategy, KPIs, and ESG governance.
At this stage, bond contracts tend to select metrics included in annual sustainability reports so investors can gauge progress.
Alternatively companies can provide relevant historical data for the past three years.
General characteristics of SLB issuance
Morgan Stanley estimates total SLBs issued since the market’s inception in 2019 to be US$57.7bn
European Union-domiciled issuers dominate the market given Europe is the ahead of the curve and is the current centre for ESG issuance.
Euros and US dollars are the currencies of choice for SLB issuers. Chinese yuan rolls in at a distant third.
No one sector dominates issuance of the SLB markets (unlike UoP markets), which may appeal to those seeking to diversify through sectors.
For example, SLBs offer investors exposure to more carbon-intensive sectors such as Materials, Energy and Industrials as they decarbonise.
As an example of non-energy sector issuance, fashion retailer H&M’s launched a E500m 8.5 year SLB in February 2021.
The SLB terms require the company increases its share of recycled materials as inputs to 30% from 0.5%; reduce Scope 1 and Scope 2 emissions by 20%; and reduce selected Scope 3 emissions by 10% against a 2017 baseline by 2025.
Issuers’ frameworks paramount to investors
The quality of an issuer’s sustainability frameworks will likely determine their ability to curry investor favour.
A corporation’s frameworks should comply with both the ICMA principles, and the United Nation’s SDGs.
The framework should also drive the three legs of ESG and include environmental, social and governance KPIs that are relevant to the core business; are measured from a baseline to avoid overstatement or double counting; and reflect the company’s geography and specific sustainability challenges.
For example, Morgan Stanley criticises a recent Enbridge Gas SLB, noting the company should have included a Native American on the board given the nature and geography of the business. General board diversity would be considered a less impactful KPI for Enbridge’s situation.
The inclusion of second-party opinion in frameworks is considered another key signal of quality, depending on the opinion provider, and, is likely to become best practice and ubiquitous.
Regular external verification of SPTs and KPI is a must and auditors or environmental consultants are expected to verify performance against these at least annually.
These expenses are expected to be paid by the issuer.
Moody’s ESG Solutions says investors should examine an issuer’s interim goals, historical KPI performance, science-based measurement criteria, level of transparency and ambition on scope and coverage; and ensure a limited reliance on carbon offsets.
“Robust commitments in these areas can strengthen the credibility of targets,” reports Moody’s.
To date most KPIs have been environmental; followed by multi-purpose KPIs. Social KPIs comprise a fraction of the total.
Structuring the bond and framework
Delving deeper into the ICMA principles, the association says an issuer’s framework should include:
Bond characteristics: financial/structural impact involving trigger events such as a coupon step-up between 10-75 basis points; or a premium/penalty payment. More innovative penalty clauses may develop.
Reporting: Issuers publish, at least annually, progress against the KPIs; verification assurance on performance impact; and information that enables investors to monitor SPT ambition.
Verification: Issuers need independent and external verification of their performance against each SPT for each KPI.
Calibration of SPTs: Issuers should provide regular disclosure on progress, just like any other significant information.
The framework should be ambitious and strategically aligned.
Keep an eye to credit ratings, and a few extra guidelines
Investors seeking the best performers and to avoid greenwashers should look for the following qualities in an SLB.
A pre-defined timeline should be set before issuance and the timeline must match the bond’s tenor and call structure.
For example, it is not ideal if the SLB is callable before the first measurement date.
Investors should also check whether the issuer is subject to regulations that may make the SPT redundant as well as geopolitical risk and geographical alignment.
Strong geographical alignment enhances the chances of an SLB’s outperformance.
Market observers also recommend investors engage in peer-to-peer comparisons, noting that the sustainability frameworks of some SLBs may not be as rigorous or ambitious as the sustainability frameworks of some companies issuing conventional vanilla debt.
Ideally KPIs should be material not just for the business but the issuer’s credit.
Investors should also check the credit rating of the issuer as there is usually a strong relationship between rating and a company’s long-term sustainability.
For example, if a company fails on ESG metrics, its credit rating could be downgraded, which would affect its conventional debt regardless, thereby reducing the incentive to rely on the call to avoid the step-up provision.
Morgan Stanley notes that investment grade issuers in low-BBB ranks will sometimes include provisions for coupon step-ups in the case of rating agency downgrades – generally 25bp per notch.
This is to compensate investors in the event of a downgrade, particularly to high-yielding debtors, and given it can affect the investment mandate.
Issuers downgraded from investment grade to high yield often experiencing widening spreads of 100-150bp over the year preceding and after the downgrade.
So they investors should have warning and the downgrade should be largely priced in then the compensation mechanism should kick in to offset losses, leaving the investor no worse, reports Morgan Stanley.
A criticism of ESG-labelled debt is that investors may have to pay a premium for features not associated with credit risk – but market observers say this comes down to the bond structure, which is where investors should keep their focus.
Morgan Stanley argues that the greenium shouldn’t be enough to cancel out the penalty mechanism.
Liquidity is also an issue. Observers point out that given demand for ESG debt is so high, many SLBs have been issued by relatively small companies without liquid capital structures.
Engagement is critical in emerging markets.
Materiality and pricing
Materiality is critical for SLBs.
For SLBs to gain investor support, they must offer a meaningful mitigation of credit risk, or an incentive. For a discussion on penalties, see the link below.
Morgan Stanley in its report Sustainability-Linked Bonds: Materiality Is The Missing Link says investors should focus on SLBs with KPIs that are material to the credit of the issuer to better align the investment with its credit risk and incentivise quality ESG targets.
“We view the SLB financing concept as fundamentally sound and believe it holds significant potential in financing decarbonisation and addressing other sustainability challenges,” says Morgan Stanley.
“We see a 5 basis point greenium emerging among highly liquid investment grade names in primary markets but the trend is less clear among high-yield issuers.
“We have not identified a consistent SLB premium in secondary markets."
Morgan Stanley expects liquidity eventually to be in line with non-SLB structures.
The analyst advises against expecting consistent premium discounts. While greeniums are still achievable, these are likely to abate over time. Already, many SLBs are trading in line with conventional bonds.
Morgan Stanley reports the SLB structure has the potential to be more material in the high-yield market where issuers are more sensitive to interest costs and are more exposed to credit-material ESG risk.
The analyst reports that in fixed-income, it is notoriously difficult to pinpoint the fair value of a security.
When ESG is added to investment mandate, it affects factors such as ratings, sector and duration, further complicating the endeavour.
Not much can be taken for granted. SLBs can trade at a greenium in the secondary market but not always.
High-yield companies tend to have higher emissions than investment-grade companies so investors are likely to see higher yields, and lower ratings within the SLB market as a proportion of overall issuance.
Morgan Stanley estimates that only half the issuers are investment grade but says those that are investment grade are likely to gain a slight greenium of about 5 basis points.
Whether a greenium will apply in the high-yield non-rated space has yet to be tested but Morgan Stanley says it is a distinct possibility.
Linked Finance The Next Big Thing Part 1 (https://www.fnarena.com/index.php/2021/09/07/esg-focus-linked-finance-the-next-big-thing-part-1/)
Linked Finance The Next Big Thing Part 2 (https://www.fnarena.com/index.php/2021/09/13/esg-focus-linked-finance-the-next-big-thing-part-2/)
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/
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