Stockholm (NordSIP) – On the occasion of the publication of the ‘Sustainability-Linked Bond Handbook: A practitioner’s guide’ by the Anthropocene Fixed Income Institute (AFII), NordSIP sat down with AFII’s CEO and Founder, Ulf Erlandsson, to discuss the new handbook and the state of the sustainability-linked bond (SLB) market.
The AFII is a philanthropically supported, non-profit organisation, producing practical research and portfolio management tools for fixed income investors and issuers. The new manual is a first-of-its-kind guide intended to advance understanding of sustainability-linked bonds (SLBs) and help scale the market for these instruments. In 186 pages, across six chapters and 44 case studies, the handbook provides a thorough review of this market segment, with something for everyone, regardless of their level of expertise.
What are SLBs?
An SLB is similar to other sustainability bonds in all aspects except for two. On the one hand, the return on the bond is associated with the ability of the borrower to meet certain agreed-upon sustainability targets. Should these targets not be met, the bond will experience a step up and compensate the investors for this failure. At the same time, SLBs are general purpose bonds, in so far as there are no projects that the proceeds of the bond are supposed to go to, as is the case in green and social bonds.
According to data from Nordea used in NordSIP’s 2023 annual review of sustainable fixed income markets, global and Nordic SLB issuance amounted to US$70.42 billion (7% of the global total) and US$6 billion (9.8% of the Nordic total) last year, respectively.
“SLBs are a financial innovation with the potential to direct billions of dollars to the decarbonisation of the global economy. These bonds allow companies and countries to commit to and finance ambitious and holistic transition plans. However, as a new product, there have been some false starts and criticisms. Our goal is to equip market participants with the knowledge to identify and invest in ambitious SLBs that offer true financial and sustainability impact,” Erlandsson says.
The Appeal of SLBs
A central theme of the handbook is the strategic use of pricing mechanisms to design ambitious SLBs. “The embedded optionality in an SLB is key to understanding its potential as a transition impact tool,” Erlandsson tells NordSIP.
“Debt contracts with these features can be appealing for a wide range of investors while also encouraging borrowers to set targets that increase their sustainability impact. If done well and ambitiously, SLBs should be very appealing investments from a financial as well as from a sustainability perspective. SLBs that offer a lot optionality should also offer a higher price. Moreover, SLBs can also be deployed in fixed income strategies in a range of ways, from pure alpha generation to sustainability risk hedging,” Erlandsson argues.
SLBs also provide positive externalities. “One of the main benefits of SLBs is that they require, by definition, the agreement, definition and measurement of key performance indicators (KPIs), to function. To this extent, SLBs also have a ‘halo effect’, in that the transparency and accountability required by SLBs will benefit all other investors, be they standard or green bondholders or shareholders,” Erlandsson explains.
Beyond financial considerations, Erlandsson uses the hypothetical use of SLBs by a sovereign as an example of how to test (Western) countries’ climate commitments. “At a time when many are worried that climate commitments seem unlikely to be met, SLBs are a good way for governments to ‘walk the walk’, and act within a serious framework that holds them accountable and protects sustainable investors against political hypocrisy or incompetence. There is a template for such an approach. As discussed in the handbook, Chile has issued credible SLBs,” Erlandsson explains.
SLBs at a Cross Roads
However, SLBs have also faced many criticisms, which the handbook seeks to address. “Politically, SLBs face the same backlash as all other sustainable investments, especially in the USA, where ESG has been incorporated into the broader culture wars that polarise political discourse,” Erlandsson says.
However, among its ESG investment peers, SLBs have also been singled out in ways that potentially undermine their appeal as sustainable investment tools. “Since the market and regulators appear to have focused on assets more than on outcomes, the general purpose aspect of SLBs has made it difficult for investors to fit them into existing sustainable investment categories. Many institutional investors whose mandate almost requires them to buy green bonds, have yet to look closely at SLBs. The EU Platform on Sustainable Finance argues that SLBs should be monitored separately from the rest of sustainable finance instruments such as green or social bonds but that, we suggest, needs to change,” Erlandsson continues.
Beyond politics and categories, there have also been issues with SLB borrowers, themselves. “Related to the transparency and accountability benefits, there have been SLB structures that lack sufficient clout where issuers have not been ambitious enough their targets. With greater scrutiny however, we believe that is changing ,” Erlandsson adds.
All of these problems have conspired to put SLBs in a tough spot. “SLB issuance was down by 25% ub 2023. If issuance continues to progress as it has recently, the viability of this market might start to be called into question. At this pace, SLBs will not be as powerful a force as i they should be. That is part of the reason for publishing the handbook, to help the market kick start again,” Erlandsson warns.
Whether as a testament to a gone-by era of creativity and financial engineering in sustainable finance or as the first of many such handbooks, this manual is certain to be a reference educational tool for sustainable investors at all levels going forward.
