Sustainability Linked Bonds – The Next Big Thing?
In recent years, sustainable investing has grown in popularity as investors increasingly seek to put their money into companies that are committed to making a positive impact on the environment.
In recent years, sustainable investing has grown in popularity as investors increasingly seek to put their money into companies that are committed to making a positive impact on the environment and society. One way that companies are raising funds for sustainable projects is through sustainability-linked bonds (SLBs).
Highlights
The sustainable bond market is growing rapidly
The green, social, sustainability and sustainability-linked (GSSS) bond market has grown at the spectacular pace of 80% per year on average since 2014. Despite this spectacular growth, it constitutes only 1% of total assets outstanding and around 2% of new issuances (x).
The sustainability-linked bond (SLB) market is one of the most rapidly growing segments of the GSSSB market.
The market in the U.S. is nascent
There are only 9 banks that acted as lead underwriters for SLB issuances in 2022 (Refinitiv).
There were 16 SLB issuances in the US in 2022 (Refinitiv).
Energy companies represent only about 7% of SLB issuances (x).
Benefits to issuers include cheaper financing, maintaining banking relationships, and marketing opportunities
Primary benefits include enabling issuers to access cheaper financing. While there is no single resource for assessing benchmarks for coupon step ups – with a coupon spread between SLBs and plain vanilla bonds of up to 100 basis points.
Additional advantages include maintaining strong relationships with banks over the course of time, as banks increasingly dedicate focus to sustainability.
Issuance of sustainability-linked facilities provide good opportunities for issuers to publish a sustainability-focused press release.
Deal size is large
ESG-linked transactions typically raise a book 30%-40% larger than their non-sustainable counterparts (x).
Benchmark size deals (USD500m+) accounted for 70% of the 2021 green volume, up from 62% in 2020 (x).
The average size of 2022 issuances in the U.S. was $864M (Refinitiv).
What are SLBs?
Sustainability-linked bonds (SLBs) are a relatively new type of financial instrument that has been gaining popularity in recent years. Unlike green bonds, which are specifically designed to fund environmentally friendly projects, SLBs are more flexible in terms of the projects they can finance.
The main difference between the two is that green bonds are tied to specific environmental targets, while SLBs are linked to broader sustainability goals, such as reducing greenhouse gas emissions, improving energy efficiency, or promoting social and economic development. This makes SLBs a more versatile option for issuers who want to demonstrate their commitment to sustainability without being limited to a specific project or objective.
Companies issue sustainability-linked bonds (SLBs) to demonstrate their commitment to sustainability and to align their financial and environmental goals. By linking the bond's financial terms to the company's sustainability performance, SLBs provide an incentive for companies to improve their environmental, social, and governance (ESG) metrics.
One of the key features of SLBs is the coupon rate, which is the interest rate paid to investors over the bond's term. The coupon rate on an SLB is typically tied to the company's sustainability performance. For example, the coupon rate may be reduced if the company achieves certain sustainability targets, such as reducing its carbon footprint or increasing its use of renewable energy. This gives companies a financial incentive to improve their sustainability performance, which can lead to cost savings and enhance their reputation among investors and other stakeholders. The coupon rates on SLBs can vary depending on the company's credit rating, the bond's maturity, and the specific sustainability performance targets that are linked to the bond's financial terms. In some cases, the coupon rate on an SLB may be lower than the rate on a traditional bond with the same credit rating and maturity. This is because investors may be willing to accept a lower return in exchange for the company's commitment to sustainability and the potential for improved financial performance.
How has the SLB market grown?
The SLB market has been growing rapidly in recent years, with issuance reaching $137 billion in 2020, up from just $6 billion in 2016. This growth is expected to continue in the coming years, driven by increased demand from investors who are looking for more sustainable investment options. According to a recent survey by HSBC, over 80% of institutional investors plan to increase their allocation to sustainable investments in the next two years, with SLBs being one of the most popular options.
Sources:
https://www.climatebonds.net/files/reports/cbi_global_sotm_2021_02h_0.pdf
https://www.oecd.org/dac/green-social-sustainability-and-sustainability-linked-bonds.pdf
https://www.reuters.com/article/us-global-bonds-jpmporgan/sustainability-linked-bond-market-to-swell-up-to-150-billion-jpmorgan-esg-dcm-head-idUSKBN2BE18H https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/sustainability-linked-bonds-in-rapid-growth-as-more-firms-tap-esg-debt-market-65049789
What is the expected growth of the SLB market?
Experts predict that the SLB market will continue to grow in the coming years as investors become increasingly focused on sustainability. Some estimates suggest that the market could reach $500 billion by 2025, which would make it a significant part of the overall bond market.
Source:
What is the regulatory and economic context for SLBs?
Regulators have been supportive of the development of the SLB market, with the International Capital Market Association (ICMA) providing guidelines for issuers to follow. In addition, SLBs have been given preferential treatment in some cases, such as in the European Union's Sustainable Finance Disclosure Regulation, which requires asset managers to disclose the extent to which their investments are aligned with environmental, social, and governance (ESG) objectives.
From an economic perspective, SLBs can help companies to finance sustainable projects at a lower cost than traditional bonds, as investors are willing to accept lower returns in exchange for the sustainability-linked features of the bond. This can benefit both issuers and investors, as companies can access cheaper funding for sustainable projects while investors can support companies that are making a positive impact on the environment and society.
In conclusion, SLBs are an important part of the sustainable investing landscape, offering companies a flexible way to raise funds for sustainable projects and investors a way to support companies that are committed to making a positive impact. As the demand for sustainable investments continues to grow, we expect to see the SLB market continue to expand in the years to come.
Examples
Several companies have issued sustainability-linked bonds (SLBs) since the introduction of this financial instrument in 2019. The performance of these issuances has varied depending on factors such as the company's credit rating, the terms of the bond, and the market conditions at the time of issuance.
Klabin, a Brazilian pulp and paper company, issued a $500 million SLB with a 10-year maturity and a 3.2% yield in January 2021, making it the lowest yield for a Brazilian company with a BB+ rating. The company's traditional bonds maturing two years earlier were trading at 3.4% on the same day in the secondary market, indicating that the SLB issuance was well received by investors.
Verallia Société Anonyme, a French glass packaging firm, issued €500 million of sustainability-linked unsecured bonds in March 2021, with a yield of 1.625%. This yield was lower than the average yield of 1.940% on comparable BB+ rated unsecured issuance in 2021, according to LCD.
Lonza Specialty Ingredients, a Swiss chemicals company, completed €460 million of sustainability-linked senior notes in May 2021 to finance its buyout by Bain and Cinven. The notes yielded 5.25%, which is inside the average yield of 5.58% on CCC+/Caa2 rated unsecured senior notes completed in 2021.
In March 2021, Greece's Public Power Corp. SA, rated B/BB-, issued Europe's first sustainability-linked, subinvestment-grade bond deal. The company offered €650 million at a yield of 3.875%, and a €125 million add-on the following week was completed at 100.75 to yield 3.709%. The yield was lower than the average yield of 4.890% for senior notes of this rating in 2021.
Overall, the performance of these SLB issuances suggests that there is demand for sustainable finance products, even among companies with lower credit ratings. However, the success of each issuance depends on several factors, including market conditions, the terms of the bond, and the issuer's credibility in the sustainability space.