Sustainability-linked bonds were billed as the next big thing when the first one was sold in 2019 but expected 2020 volume of up to €20bn has so far failed to materialise and deals remain in the wings as work continues on resolving technical issues.
The coronavirus pandemic has been the obvious impediment to the asset class taking off. But there are other obstacles that issuers are having to navigate.
Bankers nonetheless counsel against writing off sustainability-linked bonds and say that the market could see its second transaction before the end of summer as interest and enquiries remain high.
"In the coming months we expect to see more innovation in the sustainability-linked space and different structures in this format," said Cristina Lacaci, Morgan Stanley’s head of green and sustainability bonds in EMEA.
Sustainability-linked bonds, also known as KPI-linked or SDG-linked bonds, are tied to companies' ESG strategies and the UN's Sustainable Development Goals via key performance indicators. A failure to hit KPIs results in the bonds' interest payments stepping up.
The first such deal raised US$1.5bn in September for Italian utility Enel, which followed up with a similar €2.5bn triple-tranche deal in October.
At least two planned KPI-linked bonds were issued as conventional deals as the Covid-19 crisis escalated, bankers said, as borrowers shied away from additional complexity and experimentation as they dealt with the switch to working from home.
The absence of follow-up issues is also a reflection of the difficulty of creating sufficiently challenging KPI targets to weather the scrutiny of public markets in a rapidly changing world, as the coronavirus crisis has highlighted vulnerability to events outside issuers’ control.
KPI-linked issuance has flourished in the private loan market, but publishing public targets via bond deals risks attracting criticism issuers may want to avoid. Again Enel is instructive. Pricing on its deals will increase by 25bp if it fails to meet environmental targets, but the company will face criticism for setting the bar too low if its hits its KPIs - as it insists it will - during the current unprecedented crisis.
Such issues will become easier to overcome when companies can look to guidance from industry bodies, and ICMA is close to issuing such guidance for KPI-linked bonds, particularly around the selection and calibration of targets.
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The utility sector is leading the race to issue the next KPI-linked bond due to easily understood targets linked to C02 reduction and renewable energy use.
Frequent green bond issuers such as Spanish utility Iberdrola, French utility Engie, Danish renewable company Orsted and Portugal's EDP have all been mentioned as possible contenders.
Another impediment for the asset class in Europe is that the European Central Bank is unable to buy bonds with coupon pricing risk, including step-ups, under its Corporate Sector Purchase Programme - a considerable disincentive to issue KPI-linked bonds for borrowers that can otherwise access the programme.
The ECB can buy up to 40% of eligible corporate bonds and its absence can make a significant difference to execution and companies’ ability to achieve competitive pricing. Investors also appreciate the ability to sell to the ECB in choppy secondary markets.
Paul O’Connor, executive director of green bonds at JP Morgan, acknowledged the obstacle but said it is offset by appealing to other potential investors.
"The ECB buy signal is a factor in the decision about whether to introduce this mechanism but it has to be weighed on a case-by-case basis. If you introduce a KPI mechanism, you can knock out ECB buying, but gain on green investors," he said.
Other technical challenges for issuers and investors include the absence of existing pricing curves against which to price KPI bonds. But, again, such challenges are not insurmountable.
“Building a curve for a sustainability-linked bond would not be that different to building a curve in a standard green bond,” Lacaci said.
Building a smooth curve will nonetheless be more complicated if different sustainability-linked bonds from the same issuer have different KPIs, especially if those KPIs become more stretching and the size of potential step-ups increases as the market matures.
"You could potentially have transactions in the market with different KPIs to the inaugural issue,” Lacaci said.
In the case of Enel's two issues, which have slightly different targets, and KPI-linked loans, investors/lenders have not placed much value on precise KPIs to date - presumably on the assumption that issuers will achieve the targets. That may change as the market develops.
Enel’s bonds have KPIs linked to renewable energy and CO2 targets. Pricing will step up unless at least 55% of its installed generation capacity is from renewables by December 31 2021 and the company also has to achieve a 70% reduction in the average level of CO2 emissions to below 125g of CO2 per kWh by 2030.