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01-10-2020 14:21

Lessons from the infant sustainability-linked bond market

In September 2020, the first bonds aligned to the Sustainability-Linked Bond Principles (SLBPs) were issued. Even though the fledgling market provides endless opportunities for structuring sustainability-linked bonds (SLBs), a comparison of the current issuers and their bonds reveals unexpected similarities.

Last year, the Italy-based international energy company ENEL sparked controversy when it issued the first-ever target-linked bond. The format gained legitimacy in the market in June 2020 when the International Capital Market Association (ICMA) published the Sustainability-Linked Bond Principles. Since then, the market has been holding its breath, waiting for the first movers to come on the scene.

The snowball started to roll in September when three entities announced that they intended to issue SLBs. Soon after, the ECB said that SLBs will become eligible for asset-purchase programs and as collateral from 1 January 2021, which will likely attract more issuers to the SLB market.

The first-moving sectors

The green bond market has long been dominated by a few sectors, where green-eligible projects can be identified with relative ease, such as renewable energy and real estate. Comparing the four issuers of SLBs, they come from four completely different sectors. This may seem surprising, but, considering the purpose and structural possibilities with an SLB, it is clear that the format is aimed at a broader issuer base than the green bond format.

While the green format focuses on incremental steps, requiring the bond proceeds to be used for specific green projects and assets, an SLB can be used to finance an entity’s sustainability transition and overall progress. Entities from sectors where a coherent definition of what is green does not exist, or where it’s not feasible to identify the allocation of proceeds to environmentally-positive projects, now have the opportunity to publicly communicate their sustainable strategic direction with an SLB, while at the same time enjoying potential financial benefits.

One example is Suzano, which aims to decrease the carbon intensity of its pulp & paper production. A definition for green pulp & paper production has long been lacking, and the Technical Expert Group (TEG) had major difficulties developing criteria for the sector in the EU Taxonomy. This led to the sector being left out of the final version of the EU Taxonomy. With SLBs, entities in this sector now have a relevant vehicle to communicate their commitment to sustainability, while at the same time being able to provide the transparency required by investors.

Novartis, for example, would most certainly be able to issue social bonds to fund their increased patient reach, but identifying the relevant and sufficient investments needed might be a challenge. An SLB allows them to use the proceeds as they see fit to reach their communicated, socially-focused targets, providing a more flexible sustainability financing solution.

The bond characteristics

Suzano has one KPI linked to the bond issued in September. ENEL, which has issued more than one bond, has used the KPI related to installed capacity in renewable energy sources for three of their transactions and the direct greenhouse gas emissions KPI for one transaction. Novartis has two KPIs, one for each issued bond, while Chanel has linked two KPIs to one tranche and one KPI to a second tranche. The appropriate number of KPIs linked to an SLB has been widely discussed in the market, and as always it depends on the type of issuer and the type of KPIs in mind. Fewer targets allow for a more focused sustainability story and transition, which can be easier to communicate to investors, while several targets can combine different aspects of sustainability into one solution.

What all issuers have in common is that failure to meet the targets triggers a step-up of the coupon. Before Chanel entered the market last week, the step-ups had all been 25bps. It is interesting to note that the first three issuers of SLBs used the exact same structure, which was almost becoming market practice at this early stage.

Chanel broke the trend by adopting step-ups of 50bps and 75bps for failure to reach its renewable and emission targets respectively. The scope for innovation is immense for this new format, and we expect more trend breakers to enter the market and debut new types of structures to explore investor reactions.

Sustainability-linked Bond Frameworks and Second Party Opinions

ENEL, which issued its first SLB prior to the publication of the SLBPs, presented its target-linked structure in an investor presentation. Its bond later got an SPO of its commercial papers. Suzano and Chanel have published Sustainability-linked Bond Frameworks, which have been externally verified as well.

The SLBPs do not specifically require issuers to present a framework (although they reference it as a possibility) but emphasize the importance of providing investors with the relevant information prior to a bond issuance. However, market practice when issuing a green bond is to have a framework that’s verified by a second party opinion provider. We would expect this to become the de facto market standard for SLBs as well.

Investor interest in the bonds

Since the ENEL bond, SLBs as a format have gotten a mixed reception. Some investors have flagged the risk of greenwashing, arguing that the lack of transparency around how the bond‘s proceeds will be used creates a legitimacy issue for the sustainable bond market. What’s more, unlike green bond issuers, SLB issuers do have an option to not deliver on the KPI. While such criticism seems to have abated since the SLBPs were published, we are aware that investors still find it difficult to value the potential variation of the coupon.

A common appeal for interested investors is the idea of being able to buy in to an entity’s sustainable improvement. SLBs commit the full business of the issuer to a sustainable target, which by extension means that all of the company’s activities and bonds are connected to a sustainable transition. Entities are able to be transparent with how they set up their targets and how far they have come in their sustainable transition.

The first SLBs have been well received by the market, especially the ones committing to an environmental target, and the development of the market will be closely tracked. At this point, we have not yet experienced the “test date phase” of SLBs – the date when a test is conducted to determine whether the KPI has been met, potentially giving rise to a coupon step-up. We are curious to see how SLBs’ financial performance will play out, as well as the holding behaviour of investors, as the issuer approaches the test date.

Will we continue to see only step-ups, or will other changes to the bond characteristics emerge? Will entities commit to annual test dates, rather than one-time tests? We are sure to see additional SLBs issued in the short-term using a broader set of structures than what we’ve seen so far, answering some of the lingering questions and breaking new ground in the sustainable finance market.

About the authors:

Ebba Ramel is an analyst in Nordea’s Sustainable Bonds team.

Jacob Michaelsen is Head of Sustainable Finance Advisory at Nordea.

For more information

On sustainability-linked bonds contact Emma Ramel on Nordea’s Sustainable Bonds team.