Sustainability-linked bonds one year on: what have we learned?

05 November 2020

Dr Arthur KrebbersHead of Sustainable Finance, Corporates

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While green debt is about to reach puberty, sustainability-linked bonds are still very much in diapers. We take a look at what we’ve learned about them one year on.

While green debt is about to reach puberty, sustainability-linked bonds are still very much in diapers. A wide variety of market participants have projected their hopes onto this nascent asset class. It’s seen as a critical tool to “mainstreaming” sustainable finance and moving the focus from projects to companies as a whole.

How is it faring so far? In the past year we’ve seen approximately €7.5bn equivalent issued in public bond format across nine tranches, with the majority to fund companies’ environmental transition. 90% of issuance has been linked to a carbon-related target, broadly equally split between emission reduction and increased uptake in renewable energy. This highlights the broad investor understanding and support for these types of metrics, a dynamic that will likely continue after the European Central Bank (ECB) announced in September that bonds with coupon structures linked to certain sustainability performance targets will become eligible as collateral for its various market operations if they contain an environmental target1.

1. Sustainability-linked bond issuance: by key performance indicator metric

Source: NatWest Markets

 

Sustainability-linked bonds are mostly about medium-term change: none of the bonds issued so far have had a target fall within the first 25% of its lifetime (no risk of quarter-life crisis!). The average measurement event occurs in year 5 or at 60% of the bond tenor. This is a careful balancing act between setting meaningful targets while also offering a strong enough economic incentive to meet the target, for example through multiple years of residual (stepped-up) coupon payments.

2. Sustainability-linked bond issuance: target year divided by tenor of bond

Source: NatWest Markets

 

What have been the repercussions of missing the target? With the exception of one transaction, all bonds have had the same margin adjustment: “25bps is the answer, what is the question?” While this has drawn parallels with US market conventions for rating step-downs, this approach may see further differentiation in the future. As chart 3 highlights, the step-up only really constitutes a meaningful portion of the at-issue credit spread (>50%) for a third of transactions.

3. Sustainability-linked bonds: margin adjustment as a % of at-issue credit spread*

Source: NatWest Markets

 

Encouragingly, the average European sustainability-linked bond deal size is around 40% larger than a conventional green corporate debt issue (see table 4). The lack of a specific ‘use of proceeds’ restriction helps in this regard: treasury teams from a wide variety of sectors can now credibly ‘greenify’ all of their capital structure.

4. Sustainability-linked bond average deal size

Source: NatWest Markets

 

This is only the beginning. With the ICMA2 Sustainability-Linked Bond Principles now fully embedded, sustainability-linked debt is likely to undergo a growth spurt in 2021, and as with any baby it’ll start teething, ensuring that its targets carry real bite. This all means that the conventional green bond product will start to face a credible challenger in the coming years – a sibling rivalry that will catalyse the markets.

 

Thank you to Saakshi Arora for helpful research assistance

 

Notes

1 https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200922~482e4a5a90.en.html
2 ICMA  International Capital Market Association
Green bonds
ESG/Sustainability


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