SLBs, a new era for sustainable bonds investors?

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The Sustainability-linked Bonds market undergoes a stepwise growth with 20 transactions totalling $8 billion of issuances in 2021 already. Is this the beginning of an exponential growth phase and will it become the new normal? Investors’ appetite and expectations on the instrument will largely shape the answer; this is why we closely engaged with them on the matter and conducted a detailed survey. Our conviction is that Use-of-Proceeds instruments, and General Corporate Purpose instruments will coexist and that they can be mutually re-enforcing. They bring different perspectives and layers of analysis addressing different investors’ expectations. In our structuring and advisory capacities, we want to incorporate key features allowing this new segment to thrive in integrity.

The Green, Social and Sustainable market has been evolving considerably during the last decade, reaching a total of $1.4tn issuances including $490bn for 2020. Even if the market is still just a drop in the ocean of bond issuances, this last figure clearly shows that demand for green and sustainable products is growing exponentially. In this context, Sustainability-linked bonds (SLBs) have emerged, offering a new innovative way to participate in the sustainable market for both public and private debt investors. SLBs are defined as a type of bond in which the financial and/or structural characteristics can vary depending on whether the issuers achieve predefined Sustainability/ESG objectives. The SLB product could become a good complement to the green/social/sustainability bond products (with dedicated Use-of-Proceeds) because it proposes a more forward-looking and holistic view of an issuer’s profile.

Growth of the SLBs market development occurred after the publication of the Sustainability Linked-Bonds Principles (SLBPs) by the International Capital Markets Association (ICMA) on June 2020 (see our previous article “Sustainability-Linked Bond Principles: a set of guidelines to help this new product thrive in integrity”). Following the release, more than 45 issuers have raised financing through this format, reaching a total close to USD 20 billion of issuances as of March 2021. Pushing even more in the light the SLB product, the European Central Bank (ECB) then decided that, from Jan. 1, 2021, SLBs will be eligible as collateral for Eurosystem credit operations and for Eurosystem outright purchases for monetary policy purposes, provided they comply with all other eligibility criteria (see our previous article on ECB’s decision).

Yet, this segment, particularly popular among the corporates, is still nascent and opens a lot of questions for investors. Should sustainable issuers switch to 100% SLB funding? How would that be perceived by investors? Is there any possible guidance and underpinning science in determining the appropriate size of SLB issuances, the ambition of the targets, and quantum of any coupon variations? Will SLBs compete or complement Green and Social Bonds? Can any type of issuer be a legitimate SLB issuer? How to manage evolving sustainability targets and changing methodologies over time?

In a desire to better understand this innovative segment from an investor’s perspective, Natixis decided to undertake a dedicated survey at the end of 2020. This initiative sought to understand investors’ appeal, concerns, themes of interests and preferred structure characteristics for SLBs in order to offer dedicated and suitable solutions for clients.

Across the 40 global investors, managing c.USD 20 trillion AuM, almost nine out of ten (88%) declared having an appetite for SLBs. The approval is less marked when looking at green specialists (80% of approval) but still remains strong. An increasing number of investors are considering allocating sustainability-linked bonds in both their conventional portfolios (40%), as well as in their ESG integrated (66%) portfolios. Additionally, the SLB product can be a side allocation in a dedicated green bond fund, which makes it very flexible.

As mentioned previously, to date issuers are mainly corporates. Corporates come from various sectors, with a focus on ESG impact and transition pathway companies. However, public issuers or financial institutions could definitely be interested in the product as anyone with a strong sustainable target could fit. Indeed, the cornerstone of a SLB is that the bond’s financial and/or structural characteristics can vary depending on whether the core, relevant and material KPI(s) reach (or not) their predefined targets.

However, the concept of SLBs sparks questions, and investors raise some concerns. First of all, more than half (56%) fear greenwashing with the use of SLBs. The fact that Key Performance Indicators (KPIs) monitor the progress raises some doubts about the lack of comparability (40%) or even the lack of ambition of those KPIs (40%). Indeed, KPIs should be robust, material and holistic in order to achieve the predefined objectives of the issuance. The ambition of KPIs should be embedded in a long-term strategy approach rather than just focusing on short-term deliverables. Moreover, all investors expect impact reporting, including views on the levers actioned to achieve the target(s). Regarding the areas of interests for KPIs, environmental ones are broadly accepted to structure SLBs, but there is also a growing interest on social themes (70% for Health & Safety in particular).

Another particularly interesting part reflected in the survey is on the pay-off mechanism that should be considered for SLBs. Indeed, the preferred mechanism (88%) is the coupon step-up (largely because it is the only mechanism used on the market up to date), while the coupon step-down (still very rare on the market) is less welcome; whilst investors appreciate issuers to have skin in the game with SLBs, they are themselves more reluctant to a financial concession. The pay-off mechanism is a delicate question as highlighted by several investors.

To conclude, we can reassert that SLBs will be part, if not already, of the sustainable products landscape (see our previous article “Structuring formats and thematic proliferation: orientation map”). There is room and even need for innovation and regulators and central banks’ doctrine should accompany this. Since first developments of the SLB market, Natixis has seen a great potential to this innovative tool that should allow issuers to include additional sustainable features over their financing. We were delighted to structure NRG’s SLB (see previous article), which includes a groundbreaking “most ambitious target clause” and we also structured Albiomia (see here). We intend to continue engaging with market stakeholders, feel free to reach us should you discuss further the topic, and we are involved in industry-led initiatives such as chairing ICMA’s SLB sub-working on KPIs.

To go further: see the page dedicated to this survey and the replay of the webinar held on March 16