Investor perspective: the case for sustainability-linked bonds

Green bonds remain popular and account for most sustainable debt. But issuance of sustainability linked bonds (SLB) have been catching up (see chart below). SLBs are different from their Green counterparts in that the proceeds from issuance are not tied to being used on a specific project. Instead, SLB issuers must report progress on ESG objectives (through key performance indicators, KPIs) at regular intervals. If targets are not met, the bond’s characteristics are subject to change (e.g. interest paid on the debt is raised). So while SLB issuers have a clear incentive to hit these KPIs, an SLB investor can stand to gain (at least in the short term) if they are missed.

SLB issuance has been growing fast, but the market is still evolving. At present there is a lack of frequent and large issues from financials, supranationals and governments, as well as a greater presence of high-yield issuers (28% for SLBs vs 4% for green bonds]). Carbon-related targets are the most prominent in the KPIs. Over 70% of SLBs have a coupon step-up structure if targets are not met:  a 25-basis point step-up in the yield paid is prevalent.

As my colleague Daniel Sacco has pointed out to me, borrowers don’t necessarily find it easy to hit these targets. According to an analysis by the Anthropocene Fixed Income Institute of 24 SLBs from 19 benchmark issuers, three companies are likely to miss their targets this year and four have only a 50/50 chance of achieving them. Already this year one major issuer has been forced to pay higher coupons on USD11bn of its bonds and the problem could increase: most existing SLBs will face their initial observation dates in 2025.

SLB targets have also been under scrutiny. A recent report by the Climate Bonds Initiative finds that reporting on KPI progress often lacks detail, explanation or consistent data, and recent updating of ICMA’s Sustainability-Linked Bond Principles will not fix such problems entirely. At present, markets appear to be finding it difficult to accurately price the probability of KPIs being hit/missed – and thus the outlook for investment returns – something that makes (rational) investing more difficult.

So are SLBs a useful asset class? I think they are, so long as they provide a clear incentive to SLB issuers to hit credible ESG KPIs.

Figure: Global issuance of USD ESG debt by label in USD bn
Source: Bloomberg L.P., Deutsche Bank AG. Data as of Sept 2024.

Our view: demographics, financial markets and ESG

We shouldn’t forget the “S” in ESG. And one key social driver is ageing. This will have an impact not only on economies and but also on financial markets.

The economic impacts are already widely discussed. As life expectancy rises, healthcare and nursing requirements will obviously increase. A subtler point is that longer life expectancy will not necessarily correlate with longer working lives, putting an increasing strain on economic growth and government finances. This has raised doubts about the financial sustainability of many state-provided pension systems. (Germany is expected to allocate around 21% of its federal budget to the first pillar of its pension system this year.)

Private sector saving for retirement is likely to have an increasing impact on financial markets. Increased savings by younger generations could lead to greater demand for safe, longer-term investments, such as bonds – but also cause market volatility when retirees start drawing down on their savings. There also may be a negative relationship between population aging and equity market returns.  Different ageing patterns may also affect the relative attractiveness of different geographic regions as well as sectors.

How we approach the impact of ageing on financial markets has echoes of how we can approach ESG investing. Both can be seen as part of a process of a long-term transition (to more sustainable economies/ageing populations) and managing long-term risks. Demographics provide one more argument for not just considering standard traditional financial metrics.

Under debate: putting the business into sustainability

A recent report from the University of Cambridge Institute for Sustainability Leadership, “Survival of the fittest: from ESG to competitive sustainability” takes a combative stance. The authors, Lindsay Graham and Paul Gilding, argue that ESG disclosure, reporting and good governance have failed to deliver sufficient change as we try to move to a sustainable economy. On the contrary, they argue, ESG may be dangerous in that it creates the illusion of progress while far too little is being achieved. As they bluntly put it: “the problems are increasing faster than solutions are being deployed”.

The paper argues that there is a built-in tension between the pressure on companies to appear green and their operating in (what the authors describe as) “market contexts that don’t support costs of transition”.  The report therefore argues that we should “change the market”. The argument is that “first movers” in times of change will lose out in terms of competitiveness, that “strong government policy” (e.g. taxes and subsidies, mandates and bans) is needed to change this “market logic” and that firms should lobby for such changes.

I don’t necessarily subscribe to this view but the report does identify an important issue: how to move from individual to collective action in the corporate world. Current sustainability initiatives are often seen as the responsibility of individual CEOs who can come under heavy pressure to reverse them. We do need more evidence of corporate group solidarity on the need to push forward with environmental initiatives.