How sustainability-linked bonds support ESG goals

Today, companies are trying to access capital by issuing sustainability-linked bonds (SLB) aimed at ESG investors.

These are not the same as green bonds which are “use of proceeds” instruments that allocate the proceeds directly to specific green projects. Instead, SLBs require the issuer to meet some sustainability goal rather than use the money exclusively on green projects. This goal is usually measured with some kind of key performance indicator like a percentage reduction in carbon emissions. The coupons on the bond increase if the issuing firm fails to meet its stated green milestone.

The SLB market is growing fast as more people take a purpose-driven approach to investing. From 2020 to 2021 “total issuance of sustainable bonds across all sectors and asset classes rose nearly tenfold” and “increased a further 15% year over year in the first half of 2022 to $54.2 billion” according to Pimco. As recently as 2021 sustainable debt issuances exceeded $1.6 trillion in total volume.

Here we explore the rise of SLBs and how ESG-focused investors can include an allocation of green fixed income products to their portfolios. 

Why Sustainability-Linked Bond Issuances are Growing

SLB issuances are growing for three reasons:

First, many companies were previously unable to access ESG-linked financing via green bonds because they were not prepared to apply all of the necessary capital to green projects. SLBs, however, allow these companies to tap the growing base of ESG investors because the money they receive does not need to be allocated entirely to environmental projects. For this reason, several oil and gas companies in North America started issuing SLBs in 2021. Other businesses are beginning to do the same including pharmaceutical companies and fashion companies. In 2021 a total of 42 SLBs were issued representing $30 billion in financing according to the WSJ. In the prior year, there were only three issued, totaling $2 billion.

Second, the growth of SLB issuances is also due to emerging guidelines that have provided a much-needed framework for the products. For example, the International Capital Market Association (ICMA) released a set of voluntary process guidelines recommending structuring, disclosures and reporting. The ultimate goal of the document is to create the standards investors need to confidently invest in a nuanced ESG product such as an SLB.

Third, investors are becoming purpose-driven and are interested in the key performance indicators (KPIs) SLBs are using to promote green principles. Data from S&P Global Market Intelligence shows that approximately 85% of the KPIs used in SLBs are found in the following list:

• Greenhouse gas emissions reduction
• Renewable energy
• Biodiversity protection
• Patient outreach
• Waste reduction
• Water consumption
• Gender diversity
• Training initiatives

How Similar Green Bond Funds Have Performed

While SLBs are rising in popularity, investors may want to consider traditional green bond funds as an alternative for several reasons. Green bond funds:

1. Are more accessible than SLBs and are available across a wide choice of ETFs
2. Follow a “use of proceeds” mandate in which “proceeds or an equivalent amount will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible Green Projects and which are aligned with the four core components of the Green Bond Principles” according to the ICMA.
3. Will offer greater diversity in nearly all cases as many funds include hundreds of holdings.

How have green bonds performed? The chart below offers some answers:

Comparing the S&P 500 Bond Index to the S&P Green Bond U.S. Dollar Select Index

Source: S&P Global

While the performance of green bonds may not have been great which may dissuade some investors from bringing them into their portfolio - they weathered the last year slightly better than the S&P 500 Bond Index - and of course, many green bond investors seek these products not just for their return but because they bring some degree of ESG exposure to their portfolio.

Moreover, research from AllianceBernstein suggests that “ESG-labeled bonds may experience smaller drawdowns in volatile markets, helping to buffer portfolio performance.” 

How Can Investors Pursue ESG Principles in Fixed Income 

Investors have a range of options for investing in green bonds. Each of the below ETFs gives investors the opportunity to bring sustainability into their portfolio. 

• Lyxor Green Bond UCITS ETF (KLMH)
• iShares Global Green Bond ETF (BGRN)
• Xtrackers USD Corporate Green Bond UCITS ETF (XGUE)
• Xtrackers EUR Corporate Green Bond UCITS ETF (XGBE)
• Franklin Liberty Euro Green Bond UCITS ETF (XLON:FLRG)

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A FINANCE PROFESSIONAL IS STRONGLY ADVISED.