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Towards a greener future: building credibility
and demand for sustainability-linked bonds
Structural improvements seen making SLBs a more attractive sustainable investment

By Holger Mertens, Head Portfolio Manager – Global Credit
21 June, 2023

Key Takeaways— As the green bond market diversifies, sustainability-linked bonds (SLBs),
which are linked to an issuer’s broader sustainability performance, havegarnered significant investor attention and scrutiny— While the concept is compelling, concerns have arisen that theirsustainable targets are sometimes easy to beat and therefore easy to game— We believe structural improvements should help make SLBs a more
attractive sustainable investment class within the ESG universe

The green bond market has witnessed significant evolution and diversification. In 2008 the World Bank issued thefirst labelled green bond, pioneering a new approach to financing projects with environmental benefits, such as
renewable energy or energy efficiency initiatives. In 2010, at Nikko AM, we formed a partnership with the WorldBank to launch our first Green Bond Fund, which focused exclusively on investing in World Bank green bonds.
The market has continued to evolve with new types of bonds emerging to address broader social, environmental
and sustainability issues. Social bonds have been introduced to finance projects aiming for a positive social impact,
such as affordable housing, education, or healthcare. The International Capital Market Association (ICMA) has also
provided guidance on climate transition finance, focusing on instruments for companies looking to evolve from“brown” to “greener”. We have also seen the development of sustainability bonds which encompasses both green
and social bonds. However, it was SLBs—which are linked to an issuer’s broader sustainability performance andwere a departure from their more popular “use of proceeds” siblings—that have garnered most market attention(and scrutiny).
FOR SOPHISTICATED INVESTORS ONLYTOWARDS A GREENER FUTURE

For sustainable fixed income investors, the widely accepted minimum standard for investing in a bond has been set
by ICMA principles. These principles define the criteria for green bonds, social bonds, sustainability bonds, SLBs andclimate transition finance, and serve as guidelines for issuers to determine the purpose and structure of an ESG bondissuance. However, for most investors, compliance with the ICMA principles, which ideally should be verified by anindependent consultant, are just the starting point for whether a bond will be considered for inclusion into an
investment portfolio. Further research is always required, including a credit-quality assessment and in-depth
scrutiny of a corporation’s sustainability strategy.

SLBs: innovatively designed yet vulnerable to gaming
SLBs are the bond type within the group of ICMA principal bonds that has garnered the most investor debate in recent
months. The concept behind SLBs is compelling, as issuers define sustainable targets for their business and agree toaccept a coupon step-up as a penalty if the targets are not met. SLBs have made up approximately 20% of “ESG” bondissuance volume since 2021 (see Chart 1). They differ from green, social, and sustainability bonds in that the proceeds
are not earmarked for specific sustainable projects but rather for general corporate purposes, opening up the market
for hard-to-abate sectors and other companies that would otherwise find issuing green or social bonds difficult. The
pre-defined sustainable targets are implemented to ensure that companies are actively working toward a moresustainable future.
Chart 1: SLB issuance as a percentage of total ESG bond issuance
25%

20%

15%

10%

5%

0%
19

20

21

22

23 YTD

Source: Bloomberg, Dealogic, Barclays Research, Nikko AM (May 2023) Note: excludes local currency debt

The concept of accepting penalties when sustainable targets are not met is a recent innovation. However, SLBs havecome under scrutiny as investors have found that the sustainable targets defined by the issuers were quite often easy
to beat and therefore easy to game. Commerzbank 1 pointed out in a recent research paper that SLB issuers tend tohave higher greenhouse gas (GHG) emissions (Scope 1 and 2) compared with the average GHG emissions of Stoxx
600 members. Furthermore, the reduction targets of SLB issuers were less aggressive than the Stoxx 600 average.
Other questions about SLBs concern the timing of the test dates for their sustainable targets and the lack of an
independent target verification mechanism. Often, the test date occurs closer to the maturity date, leaving only one
or two years to collect the coupon step-ups. Some issuers even have the optionality to call the bonds after the penalty
is triggered, further shortening the collection period. As an example, Enbridge, a US midstream energy company,
launched an SLB in March with a maturity date of March 2033, but the first test is only scheduled for September 2031,
with an option for a 3-month par call thereafter. Another critical consideration is the low penalty payments.
Commerzbank calculated in its research that the average maximum annualised penalty is just below 15 basis points(bps).

Any reference to a particular security is purely for illustrative purpose only and does not constitute a recommendation to buy, sell or hold any
security. Nor should it be relied upon as financial advice in any way.
1

“SLBs at the crossroads”, Stephan Kippe, CFA, Commerzbank April 2023

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Easy-to-beat goals, low penalties and no independent verification mechanism have led to a slowdown in theacceptance of SLBs in the market. Investors to date have been reluctant to include them in their EU SFDR Article 9
funds given the market interpretation around use of proceeds and “do no significant harm”. This reluctance is also
reflected in bond pricing, while green bonds trade at a premium to brown bonds, SLBs do not, and they are evensometimes cheaper than brown bonds.

A stronger foundation: structural improvements for SLBs to drive demand
SLBs require further structural improvements to become an attractive sustainable investment class within the ESG
universe. The Climate Bonds Initiative (CBI), a non-profit organisation, summarised in a recent publication what it
takes for SLBs to increase in credibility and to see higher demand from sustainable investors. Firstly, an SLB with anenvironmental angle is only as powerful as the entity’s underlying transition plan and the ambition of associatedperformance targets. Secondly, SLB targets should include all material scopes of greenhouse gas (GHG) emissions(scope 1-3). Thirdly, it is advisable to avoid GHG economic intensity targets and select absolute GHG emissions targets
or intensity targets with a unit of production as the denominator. Lastly, it is important to avoid weak features in thebond structure, for example a call before the first KPI test or step-ups only kicking in at the maturity date.
The most recent issuance from TDC, a Danish telecom operator, offered an SLB structure that has the potential for
wider acceptance as it aligns closely with CBI recommendations. Firstly, TDC has implemented an ambitious climate
strategy that aims to reach net zero across its entire value chain (Scope 1, 2 and 3) by 2030. These targets received
external independent validation from SBTi (Science Based Targets initiative) and Sustainalytics, which provided asecond party opinion and classified the targets as “highly ambitious”—its highest rating. The reduction goals outlinedin the bond indenture appear ambitious and are in line with TDC’s disclosed 2030 net-zero pathway, which aims fora reduction of its Scope 1 and 2 GHG by 80% and Scope 3 by 35% by 2027. If the company fails to reach these targets,the bonds will be outstanding for another three years and allow investors the opportunity to harvest the step-up. The
only criticism to note is the step-up amount is only 12.5 bps, which could have been higher. Nevertheless, thisstructure demonstrates more meaningful progress compared with other issuances witnessed in recent months.
There is still a lot of work ahead for investors to engage with issuers to better incorporate the CBI and ICMA
recommendations and to increase the appeal of SLBs for sustainable investors. Barclays highlighted in a recent
publication that not all SLB issuers have fully embraced the ICMA SLB standards. Nonetheless, it is a worthwhile effort
to develop alternative bond structures for the “use of proceeds” category. In our view, the appeal of SLBs is clearly thefact that they require the issuer, as a whole, to move toward a more sustainable future and be willing to accept penalty
payments if targets are not met. However, we believe the definition of those targets needs more work before SLBs
will make their way into sustainable investment portfolios more fully.
Finally, it is important to emphasise that SLBs are not only important for corporate credit issuers, but even more sofor sovereign issuers. A single sustainable investment project is often not critical to an entire country. What is more
relevant is how the country treats its natural resources and the wider environment in general. Last year Uruguay andChile issued SLBs targeting nationally determined emission cuts—an exciting development that showcases thepotential for SLBs.

Any reference to a particular security is purely for illustrative purpose only and does not constitute a recommendation to buy, sell or hold any
security. Nor should it be relied upon as financial advice in any way.

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