Sustainability-linked Bond Principles mark new era for bond market

11 Jun, 2020 10:08
source: Singularity Financial

Singularity Financial Hong Kong June 11, 2020 – A set of Sustainability-linked Bond Principles (SLBP) was launched on June 9, 2020, in a landmark move that is expected to kickstart a new market of labelled bond issuance that will “complement rather than act as an alternative” to the green bond market.

The International Capital Market Association (ICMA) – the administrator of the Green Bond Principles (GBP) and Social Bond Principles (SBP) – launched the principles to develop a market for forward-looking performance-based bond instruments, in a bid to broaden the green, social and sustainability (GSS) bond market to a wider array of issuers.

Nordic Investment Bank (NIB) treasury and sustainability head Lars Eibeholm – who also serves as chair of the GBP/SBP executive committee – described sustainability-linked bonds as a “completely new instrument” which complements the traditional green and social bond instruments.

Sustainability-linked bonds incentivise the issuer to achieve material, ambitious and quantitative objectives measured through key performance indicators (KPIs) and assessed against sustainability performance targets (SPTs). These KPIs and SPTs must be determined before issuance and regularly monitored and externally verified with regards to their contribution to environment, social and governance (ESG) aims.

The release of the SLBP follow the growth in sustainability-linked loans and the first tentative steps by issuers towards performance-linked bonds, as opposed to the more traditional specific Use of Proceeds (UoP) model pioneered by green and social bonds.

Five core components of the SLBP

The SLBP are based on five core components, summarised by Natixis green and sustainable finance head Orith Azoulay, who is a member of the GBP/SBP executive committee:

1. Selection of KPIs – The KPIs need to be “relevant, core and material to the issuers overall business,” Azoulay said, as well as needing to be “measurable and quantifiable” and externally verifiable. The KPI also need to be able to be benchmarked “as much as possible using external reference”;

2. Calibration of sustainability performance targets – This is focused around the issue of what is an “ambitious” target, Azoulay said. She said it was a “mix of recommendations around what does ‘ambitious’ mean for a target and how is the target setting exercise disclosed to investors”. These targets must demonstrate a “material improvement beyond business as usual” for the issuer on each particular KPI, Azoulay added, and come with a predefined timeline consistent with their overall strategy;

3. Bond characteristics – Azoulay said a “very core” principle to the SLBP is the need for the financial and/or structural characteristic of the bond to “vary depending on whether or not the KPIs reach the predefined sustainability performance targets”. The “cornerstone” of this variation – most commonly a financial change related to the coupon – is that it should be “commensurate and meaningful” to the characteristics of the bond;

4. Reporting – This relates the pre-issuance and post-issuance reporting as well as, most importantly, transparency to investors at least on an annual basis. This reporting component requires issuers to tell investors “where it stands on its various KPIs” as well as the “verification assurance report relative to the targets, the performance against the targets, and any information that will enable investors to monitor the level of ambition,” Azoulay said.

5. Verification – Azoulay said sustainability-linked bond issuers need to secure independent and external verification for each KPI and SPT, with this verification made publicly available. Pre-issuance external review – also known as second-party opinion – has not been deemed necessary, she added, but it is “recommended to address both the compliance with those five core principles as well as the level of ambition of the targets”.

The sustainability-linked bonds are, by their nature, “not as easy” to put in a mainstream portfolio as traditional green or social bonds. This primarily centres on the financial or structural change – for example, a change in the coupon – to the bond that could be enacted by failure by the issuer to achieve the pre-determined targets.

This will require a little bit more in understanding with respect to the KPIs and the analysis of KPIs and understand how that fits into the financial performance of the instrument.

For ESG-focused investors, however, could failure to achieve targets result in them becoming forced sellers of the issue due to the sustainability credentials of the bond being unfulfilled?

“We will see if the market finds a term for such ‘fallen SLBs’,” The SLBP commented. “Obviously, the way to manage SLBs depends on each investor’s expectations and strategy, but it is clear that the step-up mechanism can act as a “hedge” for ESG investors who would need to sell the bond in the case of a failed objective. This is one of the benefit of this product.”

This added complexity and “slightly different nature” of sustainability-linked bonds to investors could lead to the instrument bringing new players into the market.

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