A brief guide to sustainable bonds

By Tom Chinery, portfolio manager, Aviva Investors

As governments, companies and investors aim for a just transition, sustainable bonds are being issued at pace in different formats. But with so many varieties on offer, making sense of them all can be a challenge.

After years where only green bonds were on offer, recent years have seen an acceleration in demand and supply. According to financial markets data provider Refinitiv, issuance of sustainable bonds totalled $544.3bn in 2020, more than double the previous year and an all-time record.

While green bond issuance of $222.6bn was also a record, the fact that 59.1% of all sustainable bonds launched last year were in other formats highlights that an entire ecosystem has emerged in recent years. However, before sustainable bonds become mainstream understanding the various offerings will be key.

Four main categories

The International Capital Market Association (ICMA) has helpfully created four sets of principles that collectively provide a framework for sustainable bonds: the Green Bond Principles (GBP), Social Bond Principles (SBP), Sustainability Bond Guidelines (SBG) and the Sustainability-Linked Bond Principles (SLBP), as well as the more recent Climate Transition Finance Handbook 2020.

ICMA-recognised green, social and sustainability bonds all have four components – use of proceeds, project evaluation and selection, management of proceeds, and reporting – to be verified through independent external reviews (second-party opinion, verification, certification and / or green bond scoring or rating).

Sustainability-linked bonds (SLBs), on the other hand, aim to further develop the key role debt markets can play in funding and encouraging sustainability; they are forward-looking than the first three types. The SLB Principles state: “The SLB must include a financial and/or structural impact if the KPI doesn’t reach its target by the predefined date. The most common is a coupon variation, but other impacts can be considered. The impact should be ‘commensurate and meaningful’.”

In most SLB cases, the coupon variation has been a commitment to increase the coupon if the issuer does not achieve sustainability performance targets by the agreed date. While this raises questions about the alignment of bondholder and issuer interests, in that bondholders stand to gain financially from the issuer’s failure to reach its targets, it can also be viewed in a more positive light.

See also: – Industry welcomes Chancellor’s UK green bond

Climate transition and sustainability themed bonds

Outside the ICMA ecosystem, the Climate Bonds Initiative (CBI) provides a ‘Climate Bonds Standard’ certification of bonds and loans as being either green or aligned to the targets set out in the Paris Agreement. The CBI does not reference the ICMA principles, though it does state that an issuer having received certification will “manage their bond proceeds properly”.

Finally, as stated by ICMA: “It is also recognised that there is a market of sustainability themed bonds, including those linked to the Sustainable Development Goals (“SDGs”), in some cases issued by organisations that are mainly or entirely involved in sustainable activities, but their bonds are not aligned to the four core components of the Principles”.

Devil in the detail

Investors first need to be aware of the source of the ‘green’ or ‘sustainable’ labelling, and then analyse the criteria to help decide whether these are robust enough to meet their investment guidelines.

Within the ICMA taxonomy, green bonds have been around the longest but, as the transition accelerates, they are beginning to look limited in scope. Proceeds have not always been used to “dark green” ends, and this has been traditionally difficult to monitor. As an example, Repsol in 2017 controversially issued a green bond with the proceeds intended to improve the efficiency of oil refineries.

Because of such controversies, green bonds have tended to be the near-exclusive purview of already green or sustainable companies, limiting the options for more carbon-intensive firms to finance their climate transition efforts. For investors, this also creates concentration risk in the green bond universe, as few sectors are represented. In addition, many ‘use of proceeds’ bonds fund prior investments.

See also: – Roundtable 1: How can credit portfolios tackle climate goals?

As the transition began to accelerate, investors needed new types of bonds that could better embrace the large transformation efforts of the wider corporate world. This ultimately prompted the development of SLBs and climate transition bonds.

One other aspect of sustainable bonds that investors and issuers should follow keenly over the coming years is how the cost of funding stacks up against conventional bonds.

Regardless of which sustainable bond investors choose, understanding what is happening at a company level, and if the proceeds will help a business become more sustainable, is crucial.

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