Sustainability-linked bonds: a nascent market that is gaining traction

• Objective Measurement: Investors must objectively measure the fair value of Sustainability-linked bonds (SLBs) to avoid overpaying for non-pecuniary features of the bond.
• Establishing Norms: As the SLB market expands, well-established norms at the issuer side and consensus among investors are essential for market efficiency.
• Transparency and Efficiency: More transparent and relevant target settings are crucial for fostering an efficient SLB market with minimal transaction costs.

Sustainability-linked bonds (SLBs) function as a performance-based debt instrument and are any type of fixed income security where the financial and/or structural characteristics depend on whether the issuer achieves agreed Sustainability/ESG objectives. They allow issuers to raise capital with financial characteristics of the bond (e.g., coupon payments) being tied to predefined sustainability targets. This type of instrument has been woven into the broader landscape of the ‘labelled bond market,’ alongside their counterparts including green, social, and sustainability bonds.

Since debuting in 2019, it took less than four years for the SLB market to pass the USD 250 bn cumulative issuance milestone (which took green bonds a decade to accomplish). At present, the outstanding amount of all SLBs exceeds 10% of the size of green bonds and represents 7% of overall labelled bonds universe. However, as the SLB market is still in its infancy and evolving, it continues to be a subject of debates and scrutiny.”

Like its counterparts, the issuance volume of SLBs have been affected by the broader fixed-income market volatility, leading to a slowdown in new offerings throughout 2022 and slower recovery in the first half of 2023 (Exhibit 1). This might also be tied to typical SLB market characteristics including the lack of frequent and large issuances from financials, supranationals and governments, as well as a greater presence of high yield issuers (28% for SLBs vs 4% for green bonds^[1]) that are particularly vulnerable to the high interest rate market conditions. Nevertheless, the demand for SLBs has remained robust, with deals often being heavily oversubscribed and attracting premiums on the primary market^[2].

Recognising the need to track the performance of the SLB market, FTSE Russell has introduced the FTSE Global Sustainability-Linked Bond Index. Taking a transparent and cautious approach, the index comprises constituent SLBs that are aligned with the five core principles outlined in the International Capital Market Association (ICMA) Sustainability-linked Bonds Principles^[3]. And we have also seen positive results with the SLB Index showing resilient performance in a challenging market environment (FTSE Global Green Impact Bond Index) (Exhibit 2).

While issuers are afforded the flexibility to establish performance targets across a wide range of sustainability topics, carbon related targets have gained the most prominence. Our analysis of the entire pool of 923 targets across 585 SLBs reveals that 88% of targets are dedicated to environmental objectives. In contrast, social and governance-related targets account for 8% and 4% respectively. Notably, carbon targets comprise almost half of the overall count of targets (Exhibit 3). And 482 SLB deals have incorporated at least one carbon target, representing 83% of the total SLB issuance count.

As of H1 2023, 35 SLBs have passed their first observation dates. Out of these, only three SLBs have failed to meet targets, with two failing short on carbon targets. Consequently, the failures have triggered coupon step-ups and led to ESG rating downgrades for certain issuers^[5]. Currently, investors tend to remain vigilant about corporates’ emission targets (including those set by SLB issuers), due to the nuances surrounding the ambition level and achievability. Going beyond SLB issuers, our recent study on emission targets of a wider scope of corporates shows, only one in three companies hit their emission reduction target for 2020 or prior^[6].

Although it has been perceived by a group of investors that to establish an effective SLB market, occasional failures should be embraced^[7], the market's resilience awaits further examination as most SLBs are set to face their initial observation dates in 2025.

It’s noteworthy in this context that carbon-intensive, hard-to-abate sectors^[8] have been among the most enthusiastic SLBs issuers. For instance, cumulative issuance amounts of SLBs have seized a considerable share and surpassed green bonds in sectors such as Aluminium, Airlines, and Cement (Exhibit 4). While green bonds in these sectors still must earmark proceeds for eligible green projects such as renewable energy installation or green buildings, SLBs serve as a complementary avenue to unlock the finance for transition. They might find greater traction among corporates especially those grappling with significant emission challenges, as the demand for transition grows more pronounced. Meanwhile, the credibility of both target settings and financial incentives requires closer scrutiny.

While there has not been a consensus on the meaningful financial and structural characteristics, issuers have embraced the coupon step-up structure, representing over 70% of all SLB targets. Our analysis found that the prevailing market practice is to employ a 25-basis point step-up, with the average basis points of step-up amounting to 10% of the original coupon. However, the market has shown a wide spectrum of variations (Exhibit 5).

Coupon attributes must be understood in the context of the underlying target’s robustness. For instance, while one could argue that a higher coupon step-up reflects the issuer's determination to meet targets, a significant step-up in conjunction with a less ambitious target may be construed as an attempt of greenwashing.

Bond holders must also take into consideration the implication of an aggressive step-up, including the strain it could put on an issuer's solvency and impact on the issuer’s credit risks. In Exhibit 5, the size of the bubbles indicates the potential total coupon payments of each bond upon step-up, highlighting a diverse range of outcomes and another layer of complication for investors to factor in their assessment. Again, understanding the ambition and achievability of targets is crucial for investors to objectively measure the fair value of SLBs and avoid overpaying for the non-pecuniary features of the bond^[9].