ESG Investing: Keeping Score on Sustainability-Linked Bonds | Lord Abbett
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Fixed-Income Insights

A growing number of bonds are tied to issuers’ achievement of ESG goals. Here’s what we look for when aligning investor and issuer interests to achieve sustainability objectives.

Read time: 5 minutes

Key Points

  • Sustainability-linked bonds (SLBs) are a relatively new, but rapidly growing, entrant into the ESG (environmental, social and governance)-labeled debt universe.
  • The distinguishing feature of an SLB is that the issuer is incentivized to achieve one or more clearly quantifiable sustainability objectives; SLBs issuers are financially penalized if they do not achieve their stated sustainability objectives.
  • When assessing SLBs at Lord Abbett, we look for strong alignment between the ESG strategy of the issuer and the sustainability goals of the bond, clearly defined and measurable objectives, and well-designed structural terms.

Issuance of ESG-labeled debt (i.e., explicitly tied to environmental, social, and governance investment criteria) continues to grow as investor demand, issuer interest, and regulatory evolution all contribute to a rapidly growing market. According to a recent report from Morgan Stanley, there is approximately US$1.6 trillion in ESG-labeled debt outstanding globally, with US$353 billion issued through April 2021 alone (see Figure 1).1 A small but increasingly relevant segment of the ESG-labeled debt market is sustainability-linked bonds (SLBs). SLBs issuance totaled US$19.7 billion year-to-date through the end of April, already surpassing the US$11.3 billion issued in calendar 2020. In this article, we will explore 1) what SLBs are, and how they differ from other forms of ESG-labeled debt, 2) why an issuer would choose to issue them, and 3) how we evaluate SLBs in our various strategies.

 

Figure 1. ESG-Labeled Debt Issuance (US$ billion)

Source: Bloomberg. Data as of 5/14/2021. The historical data shown in the chart above is for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Sustainability-Linked Bonds – An Overview

In most forms of ESG-labeled debt, a given bond will be issued in order to finance a specific project or set of projects with an environmental focus (green bonds), social focus (social bonds) or both (sustainability bonds). While there are no legal criteria defining what constitutes each of these, the International Capital Markets Association (ICMA) has established widely accepted principles for each of these types of ESG-labeled debt. These principles outline acceptable uses of proceeds (eligibility of projects; ongoing management transparency and tracking of proceeds; and ongoing reporting) and provide the foundation for the methodology for various independent certification schemes. ESG-labeled bonds are pari-passu, or of an equal status, with conventional bonds from the same issuer.

Unlike green, social, or sustainability bonds, where the proceeds are used to finance or refinance one or more discrete projects, sustainability-linked bonds (also known as KPI (key performance indicator)-linked bonds) generally have no restrictions on how the proceeds may be used. Instead, the bond’s terms are structurally linked to the issuer achieving specific and measurable targets for their broader business. In June 2020, ICMA published voluntary guidelines for SLBs, outlining best practices for issuers looking to incorporate measurable and time-based ESG-related commitments into their financing strategy.2

Underpinning every SLB are one or more key performance indicators outlining environmental, social, or governance objectives that are relevant to the issuer’s business. For example, KPIs can include target emissions reduction, percent of recycled materials used, or percent of renewable energy used. In our view, KPIs should be ambitious, material, and aligned to the issuer’s overall business and sustainability strategy. For each KPI, the issuer will define one or more measurable sustainability performance targets (SPTs), which reflect the issuer’s sincere commitment to sustainability and reflect significant changes to their business not achieved in the ordinary course of business. These targets should outline the timeframe for performance evaluation and express goals based on science-based scenarios or a relevant regulatory or governmental target. Figure 2 illustrates examples of recent SLBs alongside their KPIs and measurable performance targets.

 

Figure 2. Examples of Emissions-Focused SLB KPIs

Sources: Bloomberg, Barclays, and Lord Abbett. GHG = greenhouse gas. Carbon dioxide equivalent or CO2e means the number of metric tons of CO2 emissions with the same global warming potential as one metric ton of another greenhouse gas. The historical data shown in the chart above is for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

The key characteristic of a SLB that distinguishes it from other types of ESG-labeled debt is that these bonds contain structural or financial terms that may vary depending on whether the issuer achieves (or fails to achieve) the pre-defined sustainability performance targets. These terms could include, for example, a step-up in coupon or a premium due at maturity. In any case, the variation in terms should be meaningful relative to the KPI and to the original terms at issue. In other words, investors are compensated should the issuer fail to meet the explicit sustainability performance targets referenced in their SLB framework. Using the same example issues from above, in Figure 3, we include how the terms of the bond are changed to the benefit of the investor should the issuer not achieve their targets outlined in their KPIs.

 

Figure 3. Examples of SLB Terms

Sources: Bloomberg, Barclays, and Lord Abbett. Bp = basis point. A basis point is a financial unit of measurement that is 1/100th of 1%. The historical data shown in the chart above is for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

From an SLB investor’s perspective, transparency is key. On a regular basis, SLB issuers should publish information on their progress in achieving the KPIs, along with any related impact-metrics. Issuers should also provide external and independent validation, such as from an auditor or environmental consultancy, on their progress towards the sustainability targets. This is particularly important around the triggering dates. Third party review of progress against the targets should be made publicly available.

 

Figure 4. Comparing Traditional ESG-Labeled Bonds to Sustainability-Linked Bonds

Source: ICMA, Lord Abbett. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Why Issue Sustainability-Linked Bonds?

We have previously noted the dramatic rise of traditional ESG-labeled debt, and especially in green bonds. With such a receptive market for green, social, and sustainability bonds, why would an issuer choose to issue a sustainability-linked bond? The biggest incentive to use SLBs is the flexibility in spending the proceeds. Many companies, particularly smaller ones, do not have enough dedicated green or social projects on which to spend the proceeds of an entire bond issuance. For these companies, it makes more sense to issue an SLB which they can use for general corporate purposes, but still link it to the sustainability performance of the business. SLBs provide issuers with flexibility and provide an opportunity for investors to align themselves with specific and measurable sustainability objectives. If financial implications are material enough, it also provides investors with some reassurance that the issuer is incentivized to meet their sustainability targets.

Further, SLBs allow issuers to express their commitment to specific issues, initiatives, or development goals. As with other forms of ESG-labeled debt, the cost of financing can be lower and/or can access a wider investor base. There are also reputational benefits–internally, an SLB can demonstrate alignment to company values and business model; externally, they can also express ESG commitments in a more consequential manner.

What Do We Look for in SLBs?

As is the case with green, social, and sustainability bonds, SLBs can reflect a varying degree of authenticity in the issuer’s commitment to an ESG-related initiative. To better illustrate the characteristics of this emerging segment of the ESG bond market, we have outlined the terms and features of some recent issues, and what we specifically look for in considering SLBs for inclusion in our portfolios. A specific focus for Lord Abbett in evaluating SLBs is whether the financial terms of the bond incentivize the issuer to achieve their sustainability targets. Is the coupon step-up material enough for the issuer to be incentivized to hit the KPIs? For example, a 12.5bps step-up on a 4.5% coupon is not, in our opinion, very material. How far in advance of the bond’s maturity are the KPIs measured? If it’s only six months to a year before maturity, the financial implications of a higher coupon may not be that material. We prefer to see several years between a financial term’s measurement date and the bond’s maturity.

 

Figure 5. Sustainability-Linked Bond Investment Considerations

Source: Lord Abbett. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Closing Thoughts

Today, SLBs represent only a very small percentage of the vast amount of ESG bond issuance coming to market. That said, remember that in 2015, only US$45 billion of green bonds were issued, and we think SLBs have the potential to see a similar growth trajectory. We believe demand for SLBs from European issuers is set to remain firm–the European Central Bank recently decided that sustainability-linked bonds, including those with coupon structures linked to sustainability performance targets, will become eligible for asset purchases under the Asset Purchase Programme and  Pandemic Emergency Purchase Programme, subject to compliance with the relevant eligibility criteria. They will also be permitted as central bank collateral.3

In our view, SLBs represent a compelling opportunity for issuers to effectively communicate their ESG-goals to a wide range of stakeholders, pursue strategic objectives, and obtain favorable financing costs. Investors can align themselves with issuers that match their own ESG objectives and benefit from enhanced terms should an issuer fail to achieve its objectives. As with all ESG-labeled debt, investors must make their own determination as to whether the SLB is authentic, structured appropriately, and aligned with best practices.

Finally, an attractive SLB structure does not necessarily mean an attractive investment in and of itself, as all ESG securities should be evaluated in a broader context based on macroeconomic views and relative value. These issues–authenticity, alignment, and value–form the foundation of our approach to this nascent and exciting form of ESG bond issuance.

 

1 Morgan Stanley, ESG Labeled Debt Tracker, April 8, 2021

2 International Capital Markets Association, Sustainability-Linked Bond Principles, June 2020

3 https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200922~482e4a5a90.en.html

 

DISCLOSURE

A Note about Risk: A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

No investing strategy can overcome all market volatility or guarantee future results.

Environmental, social, and governance (ESG) criteria are a set of standards for a company’s operations that socially-conscious investors use to screen potential investments.

Green bonds: Labeled green bonds are bonds that earmark proceeds for climate and environmental projects. Labeled green bonds are often verified by a third party, which certifies that the bond will fund projects that include environmental benefits. Unlabeled green bonds (or climate-aligned bonds) are securities whose proceeds are supposed to be used for climate-aligned projects and initiatives but are issued without formal certifications.

Pari-passu ("equal footing") describes situations where two or more securities are equally managed without preference and are treated the same under various circumstances.

Under greenhouse gas protocols defined by the World Resources Institute, Scope 1 emissions are direct emissions from company-owned and controlled resources. Scope 2 emissions are indirect emissions from the generation of purchased energy from a utility provider. Scope 3 emissions are all indirect emissions (not included in Scope 2) that occur in the value chain of the reporting company, including both upstream and downstream emissions.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

ABOUT THE AUTHORS

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