Are SLBs the Right Shade of Green for Article 9 Funds?

    Stockholm (NordSIP) – In the course of discussing the performance of fixed-income funds  “investing with sustainability as a goal” and classified as Article 9 under the EU’s Sustainable Finance Disclosures Regulation (SFDR), some investors raised concerns about the appropriateness of sustainability-linked bonds (SLBs) for Article 9 portfolios.

    The issue appears to have come to the fore in April through a question from the European Supervisory Authorities (ESAs) to the European Commission (EC) enquiring about the application of the definition of “sustainable investment” to investments in funding instruments that do not specify the use of proceeds”.

    With US$275 billion in SLBs outstanding as of the end of the first quarter of 2023, the issue of whether a specific class of investors is regulatorily allowed to invest in this type of financial instrument is not trivial and could have important repercussions in the market. NordSIP reached out to asset managers, ESG service providers, capital markets dealers, and regulators to clarify this issue as it applies specifically to SLBs.

    At its core, the discussion seems to revolve around three issues: What are sustainable investments? Are SLBs sustainable? Do they fulfil the criteria of doing no significant harm (DNSH)? According to the Nordic financial market participants we enquired with, to a large extent, this issue is left to be resolved and subsequently argued by asset managers, who need to consistently motivate their decision should they choose to include SLBs in their funds.

    A Difference of Opinions

    The question of whether SLBs were suitable investments for Article 9 Fixed income funds was raised by two asset managers during NordSIP’s review of the performance of Nordic fixed income funds with sustainability as a goal during the first quarter of 2023.

    “SLBs seem to be at an inflexion point where there seems to be a skepticism and questions regarding credibility around targets. We think it’s a good instrument for companies trying to transition to be more sustainable but is requires a bit more analysis,” Karin Göranson, portfolio manager of the Handelsbanken Global Obligationer fund explained on that occasion. “By skepticism, I mean, above all, that there is a difference between whether one thinks a SLB can be in an Article 9 fund or not and that it is difficult to analyze different KPIs. This is where opinions differ. We have chosen to have the possibility of SLBs in our Article 9 funds, but a comprehensive analysis is required and it must pass our internal elaborated process,” Göranson adds.

    Others have taken a less positive view of the suitability of SLBs for Article 9 funds. “During the first quarter of the year, we realised that we could no longer buy SLBs as an Article 9 fund due to the ‘Do No Significant Harm’ (DNSH) rule in SFDR,” Cecilia Dahlstedt Myrgård, PM of the Captor Dahlia Green Bond fund. “As we interpret the SFDR, an investment cannot be classified as sustainable if it does not meet the SFDR’s requirement to ‘do no significant harm’. It then becomes difficult for us Article 9 Portfolio managers to ensure that our investment does not cause any significant damage when we finance the entire company. When it comes to green bonds, we can refer to the specific green projects (use of proceeds). This is our interpretation, and I know that other fund managers may make a different assessment. It’s an interesting question that should be addressed to get more clarity on how SLBs can/should be viewed according to the SFDR,” Myrgård adds.

    There are other concerns about SLBs. “The biggest weakness of SLBs is the uncertainty about whether the issuer will contribute to any social or environmental goal. The only thing that is sure is that a SLB will be less economically interesting for the issuer if they do not satisfy the SLB targets. Another issue is the fact that there are many SLBs with weak targets not demanding much effort from the issuer or with low financial disadvantage for the issuer if targets are not met. Issues with any of these two last characteristics are undermining the SLB market,” argues Dag Messelt, CEO and Founder of ESG consultancy SustainAX.

    Different Definitions

    Given that the definition of sustainable investments appears to be contingent on the DNSH assessment, investors should be clear on what this means and what tools are at their disposal. “There is a difference between the EU Taxonomy DNSH and SFDR DNSH definitions,” Lars Mac Key, Head of Sustainable Bonds at Danske Bank, tells NordSIP, citing a summary of the issue by Briink, a consultancy that helps companies automate EU Taxonomy reporting and SFDR assessments. “There is a set of activity level criteria that need to be met for the EU Taxonomy DNSH. SFDR requires a more general company assessment where many use the company-reported principal adverse indicators (PAIs), among other measurements.”

    Citing Briink’s opinion that “SFDR uses a broader approach and applies the DNSH criteria for both environmental and social objectives”, Mac Key notes that the core issue seems to be the need for investors to evaluate the issuer of the bonds.

    “A fully EU Taxonomy [compliant] bond should be fully compliant with the EU Taxonomy DNSH rule. All investments, be they bonds in any format or equities, require the investor to report the SFDR DNSH on an issuer level,” Mac Key adds. (emphasis added)

    Not Automatically Sustainable

    Ultimately, however, financial market participants need to ask themselves whether a specific investment is sustainable. The answer to that question is not as straightforward with SLBs than with other assets, it seems.

    “Our view is that SLBs under SFDR should technically be assessed as any other investment. They need to fulfil the asset manager’s own definition of what is a sustainable investment, and should not automatically be considered as ‘sustainable’ or suitable in an overall perspective for Article 9 fixed income funds,” says Nora Sandahl, Head of Sustainability at Datia, a Business-to-business (B2B) Software as a Service (SaaS) provider that helps the financial market navigate ESG, SDGs, SFDR, EU Taxonomy and Stewardship.

    “Chances are that SLBs could, in fact, be suited for that purpose. However, there is also a chance they might not. This is why a conservative approach is encouraged even with GSS bonds. In addition to this, some of the criticisms about SLBs’ credibility on targets and the magnitude of penalty rates could also argue against SLBs being suitable for Article 9 products without any additional reassurances on sustainability impacts,” Datia’s Sandahl adds. “As a product, SLBs are not by default compliant with the SFDR DNSH rule,” Danske Bank’s Mac Key agrees. 

    SustainAX’s Messelt appears to share the same view. “SLBs, in general, are not an appropriate asset class for funds doing sustainable investments (regulated by SFDR Article 9),” Messelt says. “As sustainable investments are defined by the SFDR as having to contribute to at least one social or environmental goal, but also do no significant harm to other goals and have good governance, the label SLB cannot qualify as sustainable investments alone, but can be in connection with for instance green bond standards and ESG research,” SustainAX’s Messelt adds. (emphasis added)

    ‘Use of Proceed Bonds’ Vs ‘Conventional Bonds’

    It seems that the confusion arises, at least in part, from the fact that investors are used to assuming, as a rule, that some investments, such as green bonds are implicitly compliant with the SFDR DNSH rule because the use of proceeds states this clearly. However, SLBs appear to occupy a middle ground, where while they have sustainability goals, they are not ring-fenced in the same way as green bonds.

    “Article 9 funds invest in products targeting sustainable investments. Many investors deem ‘use-of-proceed bonds’, such as green bonds, as compliant by default. Meanwhile, investors tend to consider that ‘conventional bonds’ need a separate evaluation to make sure they are sustainable investments and comply with the DNSH. This distinction is made because ‘conventional bonds’ finance the company’s entire balance sheet. Most often, this evaluation is performed by reviewing the issuer’s reported PAIs,” Danske Bank’s Mac Key explains. “Some investors find that SLBs need a full evaluation as they also finance the company’s entire balance sheet. But there are different views. Some investors perform full PAI evaluation also on the use of proceed bonds (such as green bonds) as the SFDR template states,” Mac Key adds.

    “The main reason [that SLBs, in general, are not an appropriate asset class for funds doing sustainable investments ] is that they are not based on use-of-proceeds [in the same way] as sustainability bonds or green bonds are. SLBs are general purposes financing with a sustainability twist,” Messelt concurs (emphasis added).

    Ulf Erlandsson, Founder and CEO of the Anthropocene Fixed Income Institute (AFII) also emphasises the dichotomy between general purpose bonds and ‘use of proceed bonds’. “Our view is that SLBs should be allowed to be held in Article 9 funds, if it can be shown that they materially contribute sustainability-wise (such as decarbonization) at the issuer level. As these are general corporate-purpose financings, the requirements in terms of proving (non)-PAIs are likely to be higher for such SLBs. The issuer-level sustainability performance would likely apply to all debt of a given entity with such a material decarbonization plan, or which a strong SLB can be a marker of. This represents a key distinction from UoP (Use of Proceed) products where the bond only, and not the issuer, is committed to sustainability,” Erlandsson says.

    “We have argued in a recent article for greenback SLBs where the financial materiality of the SLBs is increased, and ambition levels are pushed up. A greenback SLB with, for example, a decarbonisation target would provide lower cost-of-capital for an issuer that seeks to, and succeeds, in an ambitious decarbonization plan. In such a case, the investor intentionally foregoes return in terms of having had the issuer succeed to reduce emissions, which to us seems quite aligned with the Article 9,” Erlandsson adds.

    “Of course, an SLB where targets are not met should lose their eligibility for Article 9 inclusion, most likely generating forced selling from Article 9 funds. In this situation, a SLB step-up coupon would provide a hedge for investors, compared to an equivalent vanilla bond,” Erlandsson explains.

    “When looking at national regulators (e.g. AMF), we also see the opening up for transition-strategies in Article 9 funds, even if they are not there just yet. That would further improve the potential of SLBs as transition-driving instruments,” Erlandsson continues.

    Regulators’ Views

    To better understand what is and is not allowed, NordSIP decided to reach out to the Nordic Financial Services Authorities (FSAs) for guidance. The feedback seems to suggest that the specific suitability of SLBs has not been discussed as a separate matter. However, the guidance issued by the EC suggests that FSAs are allowed to consider SLBs to be suitable if financial market participants are able to show that SLBs do indeed fulfil the required criteria to be classified as such.

    According to the EC  “‘sustainable’ investment means an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly harm any environmental or social objective and that the investee companies follow good governance practices.” Moreover, in response to the aforementioned ESAs enquiry the EC answered that “the definition of sustainable investment set out in Article 2, point (17), SFDR does not prescribe any specific approach to determine the contribution of an investment to environmental or social objectives (…) [and] financial market participants in scope of the SFDR can invest in funding instruments that do not specify the use of proceeds, such as the general equity or debt of an investee company”. 

    Overall, Nordic regulators appear to not have had the opportunity to consider the issue in any more depth than the EC and are happy to apply the general rule to SLBs. “[Sweden’s] Finansinspektionen (FI) has currently no clear view on the matter – and to our knowledge it has not been discussed within the Joint Committee sub-group on ESG,” Johanna Sundberg, Senior International Coordinator for Sustainable Finance at Finansinspektionen, tells NordSIP. “The EC emphasised in its answers on April 14 (on questions submitted by the ESAs) that financial market participants retain subjective discretion to apply their own assessment method and qualifications for what is a sustainable investment,” Sundberg adds. FI’s understanding appears to be that the eligibility of SLBs as sustainable investments ”depends on whether they fulfil contribution, DNSH and the good governance criteria according to the FMP discretion,” Sundberg continues.

    Finanstilsynet, the Danish Financial Supervisory Authority, has a similar view. “Article 9 of the sustainable finance disclosure regulation (SFDR) does not limit the types of instruments that can be included in the portfolio of financial products. A financial product to which Article 9(1), (2) or (3) SFDR applies may invest in a wide range of underlying assets, including debt of an investee company, provided these underlying assets qualify as ‘sustainable investments’, as defined in Article 2, point (17), SFDR. In order to qualify as a ‘sustainable investment’ as defined in Article 2, point (17) SFDR, an investment must (1) contribute to an environmental or social objective, (2) not significantly harm any of those objectives, and (3) follow good governance practices,” Henrik Brarup Damgaard, head of ESG supervision at Finanstilsynet, tells NordSIP. “ Financial market participants must for each investment carry out their own assessment of whether that investment complies with the key criteria of a ‘sustainable investment’ and disclose their underlying assumptions and parameters, including how they have determined the contribution of the investments to environmental or social objectives, how investments do not cause significant harm to any environmental or social investment objective and how investee companies meet the ‘good governance practices’ requirement. This information must be included in the product documentation,” Damgaard adds.

    The view of Finanssivavolta, the Finnish FSA, appears to be in synch with that of FI. “Finanssivalvonta has not considered this issue yet. In Finland, Article 9 fixed income funds are able to purchase SLBs as long as they assure that all instruments meet sustainable investments criteria,” Anna Mäkipeska, Market Supervisor at Finanssivavolta, concludes.

    Image courtesy of Linda lee on Unsplash
    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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