What is the state of play with sustainability-linked bonds?

Growing appetite for ESG fixed-income strategies has led to the rise of sustainability-linked bonds (SLBs) in recent years. Unlike more mainstream green and social bonds, SLBs have fewer restrictions on the use of proceeds; issuers instead commit to improving environmental performance against key performance indicators (KPIs) and pledges. If they fail to meet those targets, the interest rate increases.

Scott Freedman, analyst and portfolio manager on Newton Investment Management’s fixed-income team, says SLBs have greater accountability for how a business achieves its pledges or KPIs than green bonds.

“This part of the market is important because it does enable greater accountability; you don't just have an environmental target,” he says. “You shouldn't always look at just the ‘E’ because the social side is very interlinked.”

As such, the bonds have found broad appeal with investors as $188.8bn was raised from 277 issuances in 2021, according to the Climate Bonds Initiative, which certifies sustainable debt market instruments.

‘Enabling greenwashing’

Nevertheless, there have been accusations that SLBs risk enabling greenwashing because of the ease with which some KPIs are met.

“SLBs, a relatively new type of bond supposed to finance polluting companies’ climate transition, are especially at risk of being used as another greenwashing instrument,” think tank Reclaim Finance claimed recently in its response to a Climate Bonds Initiative consultation on draft proposals to certify non-financial corporates and SLBs issued by non-financial corporates.

“For example, a recent investigation revealed that [some recent HSBC debt] counted as SLBs despite being linked to the disastrous East African Crude Oil Pipeline project. Because of the extreme flexibility of SLBs’ structure, even highly destructive companies can label their bonds as ‘sustainable-linked’ by only committing to marginal efforts.”

In addition, the penalties and higher rates for not meeting certain criteria may not be such a disincentive in a world of rising interest rates.

However, Newton’s Freedman says investors are increasingly making SLB issuers go further with their pledges, forcing them to lower emission intensity or stretch their social KPIs before investing.

“There are all these growing pains in what is the newest part of the labelled bond market,” says Freedman, “It needs to grow up a bit and mature.”

SLBs will play an increasingly important role in helping fund the transition of the global economy, with more funding coming from debt capital markets rather than equities, says Freedman.

“Governments, institutions, and development agencies have tried to put frameworks in place and are relying on the private sector to pick up that baton,” he explains.

And with greater awareness of SLBs, the market could continue to grow, particularly as more sectors look to use these instruments.

A ‘compelling opportunity’

Unlike the corporate SLB space, sovereign issuance has been lighter, with only two countries having launched such instruments so far: Chile and Uruguay.

Speaking recently at a COP27 panel session, Herman Kamil, head of the sovereign debt management office at Uruguay’s Ministry of Economy and Finance, highlighted the importance of SLBs in helping countries meet their environmental commitments. Kamil told attendees his department had seen “a compelling opportunity and urgent need” for a sovereign SLB that linked cost of capital to success in enhancing its environmental credentials.

He said: “We should continue to develop financial instruments that differentiate lending conditions based on a country’s contribution to the global public good because that creates the right incentive for sustainable policy making.

“This is not a company deciding its climate change commitment based on a board decision; this is a whole country rallying behind its environmental commitments.”

However, despite being pioneers in the space, there remain reservations about these SLBs – again due to their immaturity.

“One of Chile’s targets, under their SLB, is to increase the share of renewables in their energy matrix from the current 27% to 60% by 2032, which appears ambitious,” says Peter Eerdmans, head of fixed income and co-head of emerging market sovereign and FX at Ninety One Asset Management.

“Likewise, Uruguay’s targets appear quite ambitious as they come off the back of existing efforts to decarbonise electricity generation and a need to tackle the challenge of mitigating methane emissions from their indispensable cattle industry.”

Eerdmans reveals Ninety One was one of the investors consulted by Uruguay before issuing its SLB, which proved influential and prompted Chile to update its policies.