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Enhanced terms can increase appetite for sustainability-linked bonds

Sustainability-linked bonds are seen as more environmentally effective than conventional ESG bonds – and if their terms were to change, they would be more effective still.

Sustainability-linked bonds (SLBs) are increasingly used as a corporate financing instrument. Through their terms, they incentivise companies to act in a more sustainable way; if the issuer fails to meet certain pre-defined sustainability performance targets, it triggers a built-in adverse variation of the bond terms. Interest rate rises are the most common punishment. 

SLBs stand in contrast to conventional ESG bonds, which focus on a company’s use of the bond proceeds. 

As far as ESG bonds are concerned, if a company intends to use the funds for a sustainable cause – for example, by upgrading a factory to incorporate the most up-to-date manufacturing processes – the bond may receive an ESG label even where the company’s broader sustainable business practices may not otherwise be best-in-class. 

Sustainability-linked bonds grow in popularity

This relatively looser approach, with generally no adverse bond term consequences for an issuer if it fails to use the proceeds as initially advertised, has led to some hailing SLBs as a more effective tool to address overall sustainability challenges.

They are also growing in popularity, comprising 26% of the total value of ESG bonds in 2021, up from 6% in 2020.

Instead of leaving it to the conscience of investors, directing gains from a company’s poor environmental performance to ESG causes could become the default option.

That’s not to say that sustainability-linked bonds could not be enhanced. For a start, investors actually benefit from a company’s bad environmental performance through receiving higher coupon payments. In response, some investors have pledged to donate any gains they make to ESG charities. 

Instead of leaving it to the environmental conscience of individual investors, directing such funds to ESG causes could become the default option, by hard-wiring charity donations or carbon offset payments into the bond terms. 

Loan contracts may provide model for more effective terms

And rather than merely relying on sticks, it may also be possible for bond market participants to adapt some of the terms more commonly seen in sustainability-linked loans to incentivise better ESG behaviour, such as interest rate decreases as a reward for good sustainability performance. We are starting to see these features appear in certain bonds, although more widespread adoption will require some market education.

The current market and investor expectations for sustainability-linked bonds are shaped by voluntary guidelines such as the Sustainability-Linked Bonds Principles, published by the International Capital Markets Association. 

With $189bn in issuance volume in 2021 and year-on-year growth of 941%, further market guidance on the donation of gains from poor ESG performance may be desirable.

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