The sustainability-linked bond market is evolving into a more global diversified market but the debate around the quality of KPI targets that are being set is still holding it back, according to NatWest.
The SLB market was around 4% of the overall sustainable debt market in the third quarter, down from just over 6% in the second quarter and 15% in the first, but that rises to around 20% in the corporate market, according to the bank’s research.
"The SLB market is definitely evolving and we're still trying to find our feet. The KPIs are still moving around and the conversations with investors are around what is robust, material and ‘stretching’,” said Caroline Haas, head of climate and ESG capital markets at NatWest Markets.
“That to some extent is what is holding this market back because you have a full spectrum of buyers that are interested."
Investors are asking more searching questions about KPI targets, including historical performance, alignment with the Science-Based Targets initiative as well as the ambition of targets, how they link to company strategy and how they will change over time.
This year US$52.9bn of SLBs have been issued, down 15% from US$62.3bn at the same time last year, and an annual total of US$91.2bn in 2021, according to Refinitiv data.
Arthur Krebbers, head of corporate climate and ESG capital markets, described SLB growth as “significant considering the range of views on SLBs three years ago and the fact that the ICMA principles only recently had their two-year birthday”.
The International Capital Market Association's sustainability-linked bond principles were established in June 2020 and are widely viewed as the leading market standard.
Significant SLB growth is being seen in the US market as the product becomes less Eurocentric with greater uptake in emerging markets, but although the market is expanding, issuance is still concentrated in the energy and utilities and industrial and materials sectors, NatWest said.
Dollars make up around 40% of SLB issuance in the year to-date, euro issuance is 58% and sterling makes up only 2%, according to the bank's research.
"There is a lot of dollar interest in SLBs, US investors tend to be technocrats and like their technicals and these structures work very well. The problem is that we still don’t have the volumes to actually quantify the different elements of an SLB and its pricing implications for statistical analysis,” Haas said.
To ensure the quality of the targets that are being set on SLBs in the public market, a rethink may be required on the KPI targets that are being set in the private sustainability-linked loan market that has been seen as an initial (and often soft) step into sustainable finance.
"We need to almost go back into the SLL market and ensure that standards are raised because once a corporate sets its KPIs in the SLL market, it's a lot more challenging to set different ambitions in the bond market," Haas said.
The three regional loan market associations are currently working on a global update of the green, social and sustainability-linked loan principles to align more closely with ICMA's sustainability-linked bond principles, after previously adopting ICMA’s work on KPI targets.
The low level of penalties of around 2.5bp–5bp in the SLL market is also giving cause for concern as offering insufficient motivation to companies to improve their ESG performance, a criticism that is also being levelled at the higher standard step-up payment of 25bp in the bond market, particularly as interest rates rise.
"Obviously in the SLL market where there's only 2.5bp–5bp at stake, the materiality is less. We know that even 25bp in a rising interest rate environment is going to become less material, especially when we think about the trajectory,” Haas said.
Loan step-ups and step downs are currently curbed by an SPPI test under accounting standard IFRS9 that allows an adjustment to the margin of less than 5% of the credit margin, which is determining the maximum size of the margin ratchet.