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investing in sustainability linked bonds

November 2020

Demystifying sustainability linked bonds

Innovative and flexible, sustainability linked bonds could catapult responsible fixed income into the mainstream.

Responsible investment is making its presence felt in bond markets. Not before time.

Equity investors first embraced environmental, social and governance (ESG) principles with dedicated strategies and investor engagement several years ago. But, after a few false starts, fixed income is fast catching up. The amount of outstanding ESG-labelled bonds now tops USD 1 trillion. That figure is sure to rise. One reason is the arrival of an innovate new instrument, the sustainability linked bond. These securities offer investors a new way of engaging with companies on the issues that matter the most to them and have the potential to become the default form of ESG fixed income investment. In time they may even take over from traditional instruments as the standard form of credit.

Sustainability linked bonds should not be confused with green bonds, which are issued with a pledge to use the proceeds for specific environmentally-friendly projects. By contrast, companies issuing sustainability linked bonds pledge to meet specific, firm-wide objectives in a pre-defined timeframe. That gives investors the opportunity to pick issuers whose overall sustainability priorities align with their own. It also affords issuers great flexibility to find a target that suits them – regardless of their size, credit rating, sector or region.

The specificity of the objectives is important. Many investors are skeptical of green bonds because it has been difficult to gauge whether the money raised is genuinely channeled to environmental projects. Sustainability linked bonds overcome this problem as they embed a strong incentive for issuing companies to embrace more sustainable practices. That incentive comes in the form of a “penalty” feature – such as coupon step-ups or an additional payment to investors at maturity – that kicks in whenever performance targets are not met. 

Across industries and ratings

Enel, an Italian utility company, was the first to issue a sustainability linked bond in 2019. A few others have followed suit, including Brazilian pulp and paper company Suzano, Swiss pharmaceutical major Novartis and French luxury house Chanel.
Fig. 1 - Taking the lead
Examples of sustainability linked issues to-date (a selection)
Examples of sustainability linked issues to-date

Source: Pictet Asset Management

As there is no pre-requisite for a big, expensive environmental project, there is scope for smaller companies, including ones in the high yield sector, to join in, further broadening investment options. Given the large number of fallen angels this year – companies that have recently lost their investment-grade ratings – we can expect sustainability-linked bonds to be concentrated within the BB rating segment, which currently represents close to 75 per cent of the European high yield market.

We also expect financial institutions to embrace these instruments, linking ESG targets to the composition of their loan books.

There are grounds to believe that the wide range of potential sustainability-linked goals will help this instrument to gain popularity across all industries – in contrast to green bonds, which have so far largely been the domain of utilities. Retail is among the sectors that could be a rich source of sustainability linked bonds in the next few years. 

Crucially, it’s not just about the environment. While the first sustainability linked bonds have been tied to environmental targets, such as reductions in greenhouse gas emissions, pharmaceutical company Novartis has opted to focus on access to medicine in the middle and low income segments. This reflects their specific industry and strategy, and demonstrates the potential for such bonds to include tailored targets across full spectrum of ESG issues. Over time, we would expect to see more social and governance-focused targets alongside environmental ones – which would further differentiate sustainability linked bonds from their green counterparts. 

Diligence pays off

There is a trade-off to investing in these new securities however. They require greater scrutiny and due diligence.

Are the targets sensible, achievable and measurable? Are they truly aligned with ESG principles? Do the yields on offer accurately reflect the risks of the issuer? Are the penalties sufficiently high to act as an incentive for change, while still being fair?

At present, a 25bps step-up in the coupon seems to be the most popular penalty. But this is low compared to a bond's initial coupon. Ideally, the penalty would be similar to the step-ups that kick in when issuers' credit ratings are downgraded – 125bps or so. In other words, a sustainability performance target should be as important as a credit rating target. A first step of breaking the 25bps trend has been taken by Chanel. 

Demand for sustainability linked bonds has been strong. Most new issues in 2020 have come to market at more expensive levels than similar bonds trading in the secondary market, demonstrating strong appetite among investors for this type of debt. Many of these bonds now trade at a “negative premium” versus standard bonds.

While investors need to be careful not to overpay, the pricing so far is indicative of the future role that sustainability linked bonds can play.  We would expect their popularity to grow further thanks to the European Central Bank’s recent decision to include such paper in its asset purchase programmes and as collateral from January 2021. This is a significant move, particularly as ECB has previously excluded coupon step-up structures (ones triggered by ratings downgrade for instance). As eligibility is phased in, it should encourage further issuance in the coming months.

There are other factors likely to offer support. 

By aligning company-specific targets to those in EU green taxonomy and/or the UN’s Sustainable Development Goals (SDGs), the market's growth could be even more rapid. 

Bonds embedding SDGs 3, 7, 13 and 3 – which cover clean energy, climate action and good health and wellbeing – could proliferate, in our view. 

There is also scope for bonds embedding other SDG targets, including clean water and sanitation, reduced inequality and responsible consumption and production.

Across asset classes, ESG investment is rapidly moving from a niche to “business as usual”. We believe sustainability linked bonds have a key part to play in this revolution. As the market grows, they will win a greater share not only in dedicated sustainable credit portfolios but also in ordinary bond portfolio holdings. For investors, this innovation brings the opportunity to align their own ESG priorities with those of the companies they invest in, to support measurable and concrete progress towards sustainability, as well as to tap into a growing opportunity set with the potential to generate attractive returns.