Sustainability-linked bonds: On the up

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Azul has been busy cleaning up its operations.

The Brazilian airline has upgraded most of its fleet to next-generation aircraft and expects to complete this overhaul by 2027. These planes burn less fuel, as does a practice of hauling less water in the tanks on shorter flights.

Electric vertical take-off and landing aircraft are planned for short distances, while talks are underway with aviation regulators to straighten out flight paths to reduce travel time. The airline is offering carbon offsets to travelers – at less than 1% of the ticket price – to finance reforestation in the Amazon.

The target of all this is to reach carbon neutrality by 2045, five years ahead of its competitors. “If there’s a financial incentive for me to try to get there even faster, that would be very interesting,” says Alex Malfitani, Azul’s chief financial officer.

That incentive could come in the form of a sustainability-linked bond paying a step-up coupon if Azul should fail to meet its target of reducing greenhouse gas emissions. 

That’s a penalty, of course. But it’s also an incentive. If the target is met, the interest rate on the SLB would be less than on a generic bond. This would free up capital for investing in sustainability, Malfitani says. “We think a sustainability-linked bond makes total sense,” he says. “Anything that we can do to reduce fuel burn and carbon emissions is good for the environment and good for our economic health.”

This appeal comes after a wave of concerns over the past year or so damped an initial surge in SLB issuance. After Italian electric utility Enel sold the first SLB in 2019, global issuance rose to $8.3 billion in 2020 and a record $91.1 billion in 2021, according to data from Refinitiv. The growth was driven in part by a shift toward sustainability during the COVID-19 pandemic and was helped by the issuance guidance of the Sustainability-Linked Bond Principles published by the International Capital Market Association (ICMA) in 2020. 

“The market welcomed the instrument because of its novelty and the attraction of being able to focus on sustainability at the organizational level as opposed to the project level,” says Nicholas Pfaff, head of sustainable finance at London-based ICMA.

SLBs are more flexible than the more prolific green and social bonds, as there are no restrictions on the use of proceeds. Issuers commit to improving performance against environmental, social and governance (ESG) targets and link the achievement directly to the coupon paid to investors, often a 25 basis points step-up if they fail.

“It’s a really powerful structure that could incentivize a lot of change,” says Matthew MacGeoch, a senior research analyst at the London-based Climate Bonds Initiative.

Despite this promise, SLB issuance fell to $63.3 billion in 2022 and $48.6 billion in the first 11 months of 2023, according to Refinitiv. A global rise in interest rates over that period explained some of the decline, as issuers grew wary of potential step-ups and investors shied away from risk. Concerns about the structure also quelled demand, from clauses allowing them to be called before the penalty payment to weak targets, a lack of credible reporting on key performance indicators (KPIs) to monitor progress, inadequate oversight by independent verifiers, and the potential for greenwashing and lawsuits. Failure can also come from extenuating circumstances, such as Europe asking power plants to burn more coal to reduce Russian natural gas imports in retaliation for the Ukraine war. 

“Concerns were directed specifically at the use of SLBs by corporates because they had some challenges and there were few mechanisms to hold issuers accountable,” says Eva Sanchez-Ampudia, director of the enhanced-labeled bonds campaign at the Emerging Markets Investors Alliance (EMIA) in New York.

The dip in issuance led to warnings that the SLB market could collapse altogether. Djellil Bouzidi, a Paris-based academic, expert in sustainable finance and senior adviser to London-based Bankers without Boundaries, says the flexibility that issuers have in setting KPIs, targets and the timing to meet them, as well as the frequency of paying the step-up penalty and the total number of penalty payments, is much like selling a used car. The seller knows the health of the engine, but the buyer doesn’t. This can leave investors with a dud, such as a bond that can be called before the penalty kicks in or one that has an ineffectual target, he warns.

The standardized step-up is also problematic. “If you issue a high-yield bond, 25 basis points on 10% is nothing, but if your interest rate is 1% or 2% and you pay 25 basis points, this is much more interesting,” Bouzidi says.

A high penalty, he says, is needed if a missed target mars an issuer’s reputation, as this could spark a decline in the prices of its conventional bonds and shares. The standard step-up may not be large enough to compensate the investor for this, he says.

Despite all this, Bouzidi says the penalties, which are not available in green and social bonds, can drive sustainability. 

“Linking debt to environmental or social or governance incentives is a way to put some skin in the game and to move from promises to action,” he says. “But when you enter into the market with an SLB, you have to know that you will be much more scrutinized than if you issue a classic bond.”

Working out the kinks

That scrutiny has swelled, for example, with respect to the ambitions of the SLB targets. To avoid paying penalties, issuers may pursue easy targets to the annoyance of investors who want more aggressive goals. But when targets are missed, those same investors fret about the knock-on effects.

“This is a young product and there’s still a lot of market practice which hasn’t stabilized,” says the ICMA’s Pfaff. “The last two years has been a period of maturing as market participants and stakeholders collectively come to terms with what is a significantly more complex instrument than use-of-proceeds bonds.”

The growing pains have brought several improvements. These include step-downs for rewarding overperformance, something so far only used by sovereigns. Another is the use of redemption premiums of 25 to 50 basis points paid at maturity instead of calculating how many coupons get the step-up, reducing the variance of what the penalty will be. Several indicators are being used as a composite – not just one number – to evaluate KPIs, as this can shield investors from the early perception of an issuer’s failure to meet targets by providing a broader picture of how they are advancing.

A few companies have started to use hybrid structures, too. In June, Chilean paper producer CMPC issued $500 million in green SLBs that will pay a step-up rate of 60 basis points if it does not lower greenhouse gas emissions 50% by December 2030. The proceeds are being used to fund green projects and refinance debt, a combination that meets investor demand for knowing how the issuer is using the funds while also committing to a target for reducing emissions. 

Luiza de Vasconcellos, head of ESG business at Itaú BBA, says another improvement has been the inclusion of clauses that require an issuer to pay the step-up if it calls the bond before the penalty takes effect, unless it can prove that it reached the target. Brazilian car rental company Movida Participaçoes did this when it sold $500 million worth of 10-year SLBs in 2021, and others have followed suit.

“It’s a way to protect investors,” de Vasconcellos says.

A tougher challenge has been to make ambitions even bolder, in particular by including scope 3 emissions, or indirect emissions from the value chain, and not just direct emissions (scope 1) and indirect emissions from purchased energy, steam, heat and cooling (scope 2). Scope 3 accounts for more than 70% of a company’s emissions but are far harder to reduce and measure.

Anne van Riel, head of sustainable finance capital markets for the Americas at BNP Paribas, says it may be difficult for an issuer to commit to cutting these emissions, as it is not within its direct control and the data can be harder to capture.

“To put scope 3 into a bond documentation when you still have uncertainty of how to measure it, that is a big step if you don’t know exactly what you’re looking at,” she says.

De Vasconcellos says setting doable targets is key. 

“The issuer needs to know that if they make an effort the targets can be achieved,” she says. “That’s the whole idea behind it. We don’t want to set targets that are impossible to meet. But once you issue something that has the targets and the KPIs, as a company you’re in a better position to pressure internal departments to meet the target. You can say, ‘Hey, look, if you don’t do your part, we will pay more for that.’ It’s a tool for you to work with internally to make sure that the targets are met.” 

This is the case, sometimes, with boards of directors telling the finance team to do an SLB to pressure the company to improve its sustainability, helping to show the public that the company is shifting their strategy to become more sustainable as a business – and that they are not behind.

“If everybody does this and you don’t,” de Vasconcellos says, “you’ll have to explain yourself.”

Beyond 'use-of-proceeds'

Despite these challenges, there is room for growth in SLB issuance.

A driver of this is that issuers may run out of projects for use-of-proceeds bonds, and not all companies can actually find these projects in the first place. High-emitting sectors may not be able to qualify their investments in technology to reduce emissions as green bonds. Other sectors have a lot of operational expenses like agriculture, consumer goods, engineering and technology companies, and much of that spending is on the supply chain. 

Patrick O’Connell, director of responsible investing research for fixed income at AllianceBernstein, a US-based global asset management firm, says a good thing about SLBs is that more companies can issue them compared with green bonds, which require investments of $300 million to $500 million in renewable energy projects for the use-of proceeds. 

“Fortune 500 companies that have massive capex budgets can easily issue $1 billion of green bonds and spend the proceeds quickly,” he says. “The flexibility in SLBs is really helpful and can bring in more companies.”

EMIA’s Sanchez-Ampudia says that since any issuer has only a limited number of green projects they can credibly attach ESG financing to, SLBs become an even more attractive option as their scope extends beyond climate to include social and governance objectives.

In September, for example, São Paulo-based B3 issued a $700 million SLB, the first in the world for a stock exchange, with targets to create a diversity index and boost the number of women in leadership positions in the exchange. 

MacGeoch at the CBI says that a lot of companies are still in the development stage on their transition plans, meaning that as they reach the level when they can set measurable targets they will come to market with SLBs.

“As those plans and the broader dynamics for their decarbonization improve, we expect these SLBs to improve as well because ultimately I think most of these SLB issuers are setting their transition strategies at the corporate level first and then utilizing the targets within that existing corporate strategy within the SLB format, not so much the other way around,” he says. 

The rise of sovereign SLB's

The emergence of more sovereigns issuing SLBs could also spur growth in issuance. So far, the only two sovereigns to issue SLBs have been Chile and Uruguay, both of which are expected to return to the market. South Africa and several other countries in Latin America and the Caribbean are also weighing deals.

Barbados, for example, plans to raise some $295 million through a SLB or a sustainability-linked loan as part of a debt-for-climate deal backed by the European Investment Bank and the Inter-American Development Bank. The proceeds will be used to finance an upgrade of the island’s sewage treatment plant, helping to reduce chronic water shortages. 

Jaime Reusche, a senior credit offer at Moody’s Investors Service, sees more potential for Latin American sovereigns to issue SLBs.

“The main benefit is the potential to reduce financing costs while increasing incentives to pursue more sustainable policies that benefit economic activity and the environment,” he says. 

The steps to reach the issuance stage, however, are challenging. First, a sovereign must improve their green credentials, create and implement frameworks for these instruments, and start collecting and reporting on reliable sustainability indicators for them and investors to track their progress.

“It requires substantial financial investment and capacity building to develop and maintain these indicators,” Reusche says. “But over time, the benefits of SLBs will become more evident for more countries in the region and there could be a gradual increase in SLB issuance, especially if multilateral development banks also provide support to governments in the form of technical assistance to develop the necessary measurements and frameworks.”

Investor demand

Another driver for SLB issuance is the growing shift toward sustainability by issuers and investors. 

“The companies we’ve worked with are generally very serious about sustainability. This is not a purely altruistic endeavor. It is because if they don’t do it, their supply chain may be impacted, their costs may go up or they may price themselves out of the market or lose customers,” says van Riel at BNP Paribas.

At the same time, investors appreciate the transparency that comes with setting targets with KPIs, and so they encourage issuers to sell more SLBs and come up with new targets that “will push them to innovate or push the boundaries even more,” she adds. 

AllianceBernstein’s O’Connell says there is still work to be done to improve SLBs. He estimates that a third of the issues have weak structures because of their non-relevant or unambitious targets, or targets that have already been met beforehand. That is more than the 10% of green bonds with weak structures, he says.

But he expects the improvements will come like with ESG bonds.

“As more companies are making energy transitions, this is a really natural path that if you don’t have a large capex project and you want to signal that intention,” he says. “I think that signaling will remain strong. And an SLB is a really easy way for a company management team to say they’re taking this seriously.”

For issuers in emerging markets, a high quality SLB allows them to tap into a large pool of sustainable financing, including by attracting new investors, says EMIA’s Sanchez-Ampudia. Uruguay, for example, had 40 new investors participating in its SLB.

“You can access portfolios that are not emerging markets-focused, but ESG focused and so have less volatility,” she says. “And you can issue at tough times in the market.”

Latin America

Latin America could lead some of this expected recovery, with SLB issuance holding steady at just above $11 billion over the past two years after peaking at $16.9 billion in 2021, according to Refinitiv. This was helped by Chile and Uruguay coming to market, the only two sovereigns in the world to sell SLBs.

“Latin America is always looking to bring in foreign capital, they’re willing to be innovators, they’re willing to be pioneers, and SLBs are a good way to get that message across,” says O’Connell. “If entities in Latin America are waving a really interesting structure, putting in relevant, ambitious targets out there, that is a good way to get eyeballs and people to open their wallets to look at different structures.”

He expects targets to widen from carbon emissions to boosting female management, improving biodiversity and protecting species, encouraging more corporates and sovereigns to issue SLBs.

“We’ve engaged with some of the other larger countries in the region who recently issued either green or social sovereign bonds,” O’Connell says. “I think they’re very open to what comes next, to potentially issue a SLB to show the impact in a very quantitative metric way.” LF

• Sustainability-linked bonds: On the up
• Brazil: Betting Big on Carbon
• Market Talk: Bonds
• Market Talk: Equity
• Market Talk: M&A
• Market Talk: Loans
• Sovereign Bonds: Eyeing Opportunity
• Corporate Liability Management: A Question of Maturity
• Mexico Investment: One Way Bet?
• Parting Shot – Sergio Abreu: Fixing a Fractured Region
• LatAm Banking: Taking Shape

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