A glossary of green and sustainable bonds

By Kenny Watson, fund manager, Liontrust Sustainable Investment Fixed Income

2021 saw significant growth in green and sustainable bond markets, driven by regulation, environmental targets and increasing investor demand

For issuers, these bonds offer scope to broaden their investor base, demonstrate their commitment to sustainability and potentially access better pricing. There has been a significant surge in sustainable bonds in recent years, accelerating in 2021. For the nine months to the end of September, supply was almost twice that of 2020 and increased by 17% in Q3 compared to the same period a year earlier.

Here, are the key characteristics for the different types of sustainable bonds.

Sustainability-linked bonds (SLBs)

These are bonds for which issuance proceeds are not ring-fenced for green or sustainable purposes and may be used for general corporate projects. They are guided by voluntary sustainability-linked bond principles which are designed to promote integrity and transparency in the sustainable finance sector:

• Selection of Key Performance Indicators (KPIs)
• Calibration of Sustainability Performance Targets (SPTs)
• Bond characteristics
• Reporting
• Verification

Issuers commit to improvements in sustainable outcomes within a predetermined timeline; if they fail, the coupon typically steps up by 25 basis points as a penalty.

SLBs enable more issuers to access sustainable bond markets, including those in sectors/activities that are challenged from an ESG standpoint or have low capex requirements. They reflect a commitment at issuer level – whereas green and social bonds tend to be more focused at the use of proceeds – with pledges to making long-term sustainability changes to business models. These bonds also offer greater flexibility as they can be used for general corporate purchases, re-financing and acquisitions.

However, timing of any coupon penalty can be in the last year of the bond’s maturity and step ups are typically not large enough if issuers fail to meet their promises.

Green bonds

Being green does not necessarily make a bond a good investment: success measured in coupon and capital repayments depends on the financial health of the issuer.

For credit investors, there is no difference between green and conventional bonds: the green classification does not change the risk profile as this is driven by the underlying credit quality of the issuer.

Considerations include:

• Use of proceeds: should be designated for green projects.
• Process for project evaluation and selection: issuer transparency of the project’s sustainability objectives and process.
• Management of proceeds: should be held in a distinct sub-account and tracked throughout the life of the project, with a high level of transparency.
• Reporting: kept up to date and readily available,

The unique structure of green bonds can raise concerns. Although proceeds are used for green projects, debt is serviced by the issuing firm as a whole, with coupon and principal repayments made by the overarching entity.

Bank of England – greening of corporate bonds

As part of the UK’s net zero goals, the Bank of England has announced a reinvestment programme for its corporate bond purchase scheme, the first central bank to do so. Introduced in 2016, the scheme purchases investment grade sterling corporate bonds issued by companies judged to make a material contribution to UK economic activity. The BoE’s aim is to lower its carbon footprint by focusing on reducing the tonnes of CO2 per £million revenue of this portfolio, with a target of a 25% cut in carbon intensity by 2025 to align to a net zero by 2050.

Companies must satisfy climate-related eligibility criteria for their bonds to be purchased, with the scheme tilted towards stronger climate performers within sectors. The extent of this is assessed against four metrics: emission intensity of activities, progress in reducing emissions, publishing a climate disclosure, and having an emissions reduction target (with more credit if this is third party verified). Requirements are expected to escalate over time and the Bank can take action against weaker performers, including reduced purchases, removal of eligibility or even divestment.

Green gilts

The UK priced its first green gilt in September 2021, with a 12-year maturity and a £10 billon issue size. HM Treasury will report on the social benefits of the expenditure as well as the environmental impacts every two years and proceeds can be used for six categories: clean transportation, renewable energy, climate change adaptation, energy efficiency, living and natural resources and pollution prevention and control.

Social impact and sustainability bonds

Social impact bonds aim to finance solutions to social problems including youth unemployment, long-term health issues and homelessness. Investors finance projects at the start and receive payments based on results achieved against set targets. They do not offer fixed rates of return and repayment is dependent on the project’s success. If it fails, investors face significant losses and these bonds therefore are high risk. 

Proceeds from sustainability bonds are used exclusively to finance a combination of green and social projects. Issuers produce investment frameworks covering use proceeds, project selection and evaluation, management of proceeds, and reporting, which requires third-party verification to ensure that proceeds are used as promised.

While far from perfect, the rapid growth in sustainable-linked bonds is a positive development for ESG, as it broadens the issuer base by company and by industry, allowing a wider spectrum of companies to demonstrate their increasing commitment to improve their sustainable and environmental metrics.