The sustainability-linked bond (SLB) market remains in its early stages but is growing in popularity. GAM Investments’ Andrew Dewar takes a closer look at these unique environmental, social and governance (ESG) instruments which can provide tangible economic incentives for companies to improve their long-term sustainability practices.
ESG themed bonds, in particular green bonds, have seen staggering levels of growth over the past few years. As shown in chart 1 below, in Q1 2021 USD 104 billion of ESG-themed bonds were issued, over 55% of the total issuance in 2020, putting the market on track for another record year. The proportion of ESG themed bonds within the total corporate bond market is also growing: in Q1 2021, 23% of euro investment grade issuance came with an ESG label (up from 9% in full year 2020).
Chart 1: Corporate ESG bond issuance on track for a record year (USD billion)
The majority of ESG-themed bonds are ‘use of proceeds’ bonds, funding specific green, social or sustainability projects. However, there is an increasingly popular new type of ESG bond growing, which we believe has the potential to drive change in issuers’ long-term sustainability practices; these are known as SLBs.
SLBs, not to be confused with sustainability bonds, are instruments in which the issuer signs up to meet predefined sustainability targets. Failure to meet these targets results in a change to the bond terms which are beneficial to the investor, such as a coupon step-up or payment of a higher principal at maturity. The sustainability targets selected are to be material to the issuer’s overall business: measurable, externally verifiable and benchmarked.
Unlike green, social and sustainability bonds, SLBs do not have use of proceed restrictions and funds raised do not have to be used for sustainability-linked projects. However, the key point of the bonds is to commit the issuer to making long-term sustainability changes to their business model.
A prime example would be a recent issue from Ahold Delhaize, a Dutch food retailer, where the firm was committing to reduce scope one and two CO2 emissions (as classified by the Greenhouse Gas Protocol Corporate Standard) by 29% from 2018 baseline figures and reduce food waste by 32% from a 2016 baseline. Failure to meet these targets by 2025 would result in a step-up in the coupon of 25 bps. It is not solely environmentally-linked key performance indicators that are being issued, with some being tied to gender diversity levels, access to medication and access to employment for underprivileged people.
SLBs are attractive to investors as a tool to drive material sustainability changes. Should the issuer meet its targets, it reduces its sustainability risks and therefore as a result, it becomes a more attractive company to invest in. Failure to meet its targets results in a higher return on the bonds. The product is also favourable to issuers as it could allow them to raise debt at a lower cost, should they meet their targets, than a general issue bond.
As this is still a nascent market, we need to remain vigilant of the deals, ensuring issuers are setting realistic and ambitious targets and not simply using this product as a PR exercise. Also, standardisation is still lacking in SLBs which makes pricing bonds with one another difficult. To aid in increasing standardisation, the International Capital Market Association released a set of principles in June 2020 which is helping to spur growth in the market; in Q1 this year we saw more issuance of SLBs than all of 2020 (USD 10.2 billion versus USD 7.9 billion in 2020).
We believe SLBs are an encouraging and unique ESG product that can provide tangible economic incentives for companies to improve their long-term sustainability practices and drive material change. At GAM this is a growing area of the market demanded by investors who are looking for accountability in the companies they are engaged with and we expect SLBs to be a bigger part of our portfolios going forward.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers.