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Understanding Sustainability-Linked Bonds: Examples, Challenges, and Investor Vigilance


Understanding Sustainability-Linked Bonds: Examples, Challenges, and Investor Vigilance
Corporate bonds that finance environmental, social, and governance (ESG) initiatives continue to attract investors' attention. However, it is crucial for investors to distinguish between genuine ESG bonds and those that falsely claim to be ESG bonds, as they come in various forms.
Two types of bonds, use-of-proceeds bonds (UOPs) and sustainability-linked bonds (SLBs), exemplify the importance of careful examination. ESG-labeled bonds have evolved into two main categories: project-based and target-based. UOPs fall into the project-based category and include green bonds and social bonds, which companies issue to fund their environmental or social programs. The UOP bond market, valued at nearly $1 trillion, has a longer history and is relatively efficient in terms of pricing.
On the other hand, SLBs belong to the nascent target-based submarket and face growing pains. Unlike UOPs, SLBs are designed to incentivize issuers to raise ESG standards across their entire business rather than funding a specific initiative. Issuers set key performance indicators (KPIs) to measure progress towards ESG goals, and most SLBs include a potential coupon increase if the goals are not met. However, since KPIs are self-determined, ensuring consistent and ambitious results can be challenging, and coupon step-ups may not occur even if ESG targets are seemingly missed.
When issuers fail to meet relevant KPIs, the coupon step-up serves as compensation for potential credit quality downgrades, protecting investors from bond price deterioration. However, missing KPIs also means that investors are not achieving their ESG objectives, which was a significant reason for their investment. Therefore, further investigation is warranted in such cases.
Consequently, SLBs require close monitoring to prevent greenwashing, which involves companies misleading investors about their commitment to environmental improvement. Our research indicates that until these challenges are addressed, the SLB market will experience varying spreads and other unique characteristics.
A comparison of "greeniums," the negative yield premium of a green bond compared to conventional bonds issued by the same company, highlights the less mature and inconsistent nature of the SLB market. Although the sample size for SLBs is smaller due to their recent emergence, we found that UOPs currently have an average greenium of 1.5 basis points (bps), while SLBs exhibit an average discount of -2 bps. Furthermore, the distribution of greeniums in the UOP market appears more regular, whereas in the SLB market, it seems sporadic. This difference can be attributed to the UOP market's greater depth and varying levels of KPI ambition. As the SLB market matures and expands, we expect this discrepancy to decrease, resulting in a more organized market.
ESG scoring serves as another tool for investors to compare issuers and assess potential success. By applying our proprietary ESG scores, which consider factors like industry type, ESG goals, policies, and legal actions, investors can make informed decisions. Currently, UOPs have an average ESG score of 6 on a 10-point scale, one point higher than SLBs. Similar to greeniums, the distribution of ESG scores for SLBs appears more erratic, indicating a higher risk of greenwashing. However, this distortion also stems from the scarcity of SLBs in a relatively new market.
Exploring Three Examples of Sustainability-Linked Bonds in Action
The nature of the SLB market demands cautiousness and attentive selection from investors. Some issuers face challenges but manage to recover or successfully meet their KPIs.
One such example is Enel, an Italian utility company that was an early adopter of SLBs. Enel set targets based on the United Nations Sustainable Development Goals, focusing on areas like greenhouse gas (GHG) reductions and increased use of renewable energy sources. In 2022, Enel achieved its ambitious sustainability goals, avoiding a coupon step-up or negative impact on spreads compared to its conventional bonds.
While missed targets don't necessarily indicate failure, they do warrant closer examination. Public Power Corporation (PPC) based in Greece, for instance, failed to achieve its year-end decarbonization target for 2022. As a result, its coupon was increased by 25 basis points in March 2023. PPC's failure to meet its ambitious goal (a 40% reduction in GHGs from 2019 to 2022) was mainly due to the Russia-Ukraine conflict, which disrupted its plans to transition from coal plants to natural gas. Nevertheless, PPC has reiterated its commitment to growing renewable energy and closing all coal facilities by 2028. Despite this setback, PPC's greenium reached new highs by June 2023, indicating a positive market response.
However, not every challenging situation is overlooked. JBS, the largest meat processor in the world based in Brazil, faced a whistleblower complaint in January 2023, alleging misrepresentations behind its $3.2 billion in SLBs. The advocacy group Mighty Earth pointed out JBS's increasing GHG emissions, particularly Scope 3 (indirect) emissions, which contradicted the company's pledge to annually reduce GHGs towards achieving net-zero emissions by 2040. As the Securities and Exchange Commission investigates the matter, the market has scrutinized the bonds. Following the news in January 2023, the SLBs' greenium declined and, except for a brief recovery, continued to underperform the company's comparable non-labeled bonds as of June 2023.
The SLB market presents opportunities, but as a newcomer to the ESG space, it will require time to stabilize, similar to the initial period for UOPs. In the meantime, reliable SLBs can offer attractive yields and align closely with investors' ESG objectives. However, caution is advised when dealing with questionable or problematic SLBs. To differentiate between them, investors must conduct thorough research, including fundamental credit analysis, and closely monitor each company's progress towards its sustainability goals.
Please note that the views expressed here do not constitute research, investment advice, or trade recommendations. They may not represent the views of all AB portfolio-management teams and are subject to potential revisions over time.
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