Looking Behind the Label

    Just a few years ago, the sustainable fixed income market was limited to the issuance of green bonds. Since then, however, it has developed to include an array of debt instruments. The family has expanded to social and sustainability bonds and branched out into a variety of more specific alternatives, like pandemic bonds.

    Annemieke Coldeweijer, Co-Lead PM, Euro Credit Sustainable Strategies, NN Investment Partners

    Prominent among those innovative fixed income instruments are sustainability-linked bonds (SLBs). Due to their more flexible structure, SLBs provide an alternative solution to transitioning companies, which are unable to issue project-related green bonds. However, that same flexibility means that they need to be handled with extra care.

    Annemieke Coldeweijer, Co-Lead PM of the successful Euro Credit Sustainable strategies at NN Investment Partners (NNIP), guides us through some of the pros and cons of these innovative fixed income instruments. To start with, she admits she finds it challenging to strike the right balance between being supportive and critical of SLBs. “There is definitely plenty of room for improvement when it comes to SLBs,” she says. “Yet we try to keep an open mind and apply a constructive approach to these newcomers,” she adds.

    Driving Transition

    So, what are SLBs and what makes this particular type of bond special? According to the International Capital Market Association (ICMA), an SLB is a bond with financial or structural characteristics that vary, depending on whether the issuer achieves some predefined sustainability objectives. It is a forward- looking, performance-based instrument with a flexible structure. SLB issuers define some key performance indicators (KPIs) aligned with their sustainability strategies. This allows the issuers to set more general, overarching sustainability goals rather than being tied to financing specific projects like solar power plants or green buildings.

    “We quite like the fact that SLBs push for specific change on a company level and can therefore have an impact in the real world, which is exactly what we are looking for with investments in our sustainable credit strategy” says Coldeweijer. “There is certainly a role for SLBs to play as a complementary financing tool for those companies that are unable to find enough possibilities to issue bonds that require dedicated projects to be financed,” she adds.

    Plenty of Pitfalls

    Yet, the very same flexible structure of the SLBs gives rise to some doubts as well. Moving away from the established use-of-proceeds structure means that investors have less transparency about how the issuer of the bond will use their money and how much impact it could generate. “With no clear framework, it is still very much a matter of trial and error,” comments Coldeweijer.

    Another pitfall that investors should watch out for, according to Coldeweijer, is the customised KPIs that SLBs’ issuers choose. “Unfortunately, these are not always ambitious enough, she says. “We would like to see issuers choosing bold targets, preferably verified by an external party, such as the Science-Based Target Initiative. Also, they should realise that a Scope 2 emissions-related target is not enough and take that extra step to set Scope 3 emissions goals. In the selection process for our sustainable credit strategy, trying to align with the below 1,5-degree Celsius scenario is very important and that includes Scope 3 emissions,” she adds.

    In addition, there are concerns that customised KPIs could make it easier for issuers to indulge in “sustainability washing” by moving the goalposts and tweaking the objectives to suit their needs. “All in all, from the investor’s perspective, it is important to be critical and to evaluate whether the KPIs of an SLB are robust and that all the checks and balances are in place to ensure this is the case,” advises Coldeweijer. “But there is also a need for more transparency. Investors should have more information on what the company’s position is vs the targets set and what concrete actions are taken. Not only at issuance or maturity of the bond, but also during the lifetime,” she says.

    There is also a potential moral hazard for investors in SLBs. A standard structure for these instruments includes a coupon step-up feature. It means that an increase in interest rate payments is triggered when an issuer doesn’t meet the predefined sustainability objectives. The investor will, thus, benefit from a company’s failure to deliver on its sustainability ambitions and goals.

    Just Like Any Other Bond

    “The truth is, not many of the SLBs issued so far meet our sustainability standards,” says Coldeweijer. “We don’t treat them differently from any other bonds, really. We apply the same careful analysis, focusing on the issuing company’s sustainability profile,” she explains.

    Coldeweijer guides us through the key features that she and her colleagues are looking for when analysing an SLB. “As always, it is important that the issuer is committed to a more sustainable future and its SLB framework and sustainability strategy are well aligned. Transparency and corporate disclosure are key when it comes to assessing the impact of an SLB and a company’s ESG targets and achievements,” she explains.

    Data and reporting on sustainability are still a challenge for both companies and investors, and although increasing regulatory requirements are improving standards, there is a long way to go. “This is why in our bond selection process, we do not rely solely on data from the companies themselves or on third-party ESG data sources alone,” says Coldeweijer. “We carry out our own thorough ESG analysis of the issuer, both qualitatively and quantitatively. This ensures we develop a proprietary view on the sustainability performance before investing in any issuer and in any bond,” she adds.

    Coldeweijer’s balanced scepticism toward SLBs is manifested in NNIP’s Sustainable Credit portfolio, managed by her. Currently, there is only one SLB in the portfolio. According to her, she pays more attention on whether companies have ambitious sustainable targets and are Paris-aligned, rather than on their ability to issue labelled bonds.

    “In the end, SLB is just a label, and labels do not release you from doing your own analysis as an investor and being critical of the company you invest in, labelled or not. It is what is behind the label that really matters,” concludes Coldeweijer.

    Julia Axelsson, CAIA
    Julia Axelsson, CAIA
    Julia has accumulated experience in asset management for more than 20 years in Stockholm and Beijing, in portfolio management, asset allocation, fund selection and risk management. In December 2020, she completed a program in Sustainability Studies at the University of Linköping. Julia speaks Mandarin, Bulgarian, Hindi, Russian, Swedish, Urdu and English. She holds a Master in Indology from Sofia University and has completed studies in Economics at both Stockholm University and Stockholm School of Economics.

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