The past 12 months have been challenging for bond offerings globally, and there was no exception for US sustainability-linked bonds (SLBs)—bonds with interest rate margins increasing or decreasing in line with compliance with agreed upon sustainability key performance indicators (KPIs). SLB issuances in the US fell by more than a third (34%) year-on-year, down from US$24.1 billion in 2021 to US$15.88 billion last year, according to Dealogic.
The still nascent SLB space did not prove as resilient as US investment grade corporate bond issuances, which only slid by 19% year-on-year in 2022, but did perform significantly better than the US high yield bond market, where issuances fell by 78% year-on-year in 2022 to US$96.5 billion, the lowest level since 2015. The drop in US SLB issuances, by contrast, was not only significantly smaller than the slide in the high yield space, but also saw issuances finish 2022 well above pre-pandemic levels.
The decline in SLB activity in the US mirrors a similar slowdown at the global level, with the US$60 billion in global issuances 37% below 2021 numbers, according to Barclays and Bloomberg figures reported by the Financial Times. This was well shy of optimistic forecasts that anticipated SLB issuances would top US$200 billion in 2022 and surpass the green bond market (where bonds are issued exclusively to finance specific green projects).
Wider finance contraction filters into SLB space
SLB issuances fell in 2022 for the first time since 2020, when they started to deliver meaningful levels of activity. Issuances increased more than tenfold in 2021, as lockdowns lifted and investor focus on climate change risks and sustainability intensified.
The combination of inflation, rising interest rates and climbing energy prices produced a contraction in lending activity in 2022 that filtered down to SLB issuances. While the past year may have been disappointing for SLB stakeholders, the long-term trajectory for SLBs remains broadly positive.
The market’s resilience is underpinned by long-term drivers that are set to keep appetite for sustainability-linked debt at a high level in the coming years.
Managing climate risk has become a policy priority for governments not only in the US, but also in Europe and beyond. Both the Biden administration in the US and the European Commission have put multibillion-dollar incentives and subsidies in place through the Inflation Reduction Act and REPowerEU Plan to encourage investments supporting sustainability initiatives.
According to McKinsey, these initiatives are crucial to ensure net-zero targets are delivered, calculating that approximately US$275 trillion will have to be invested by 2050 (that equates to US$9.2 trillion annually) to deliver net-zero targets. Government policy alone, however, will not be enough to deliver on these ambitions. Private sector capital will have an essential role to play and key SLB mechanisms are now being established to funnel more institutional capital into helping to meet climate and sustainability goals.
Larger SLB capital pools are also expected due to a wider pivot to more ESG exposure across the asset management industry. Recognizing that consumers and retail investors are increasingly seeking to align their investments with socially and environmentally conscious financial institutions and businesses, asset managers are set to increase their ESG-labeled assets under management (AUM). According to PwC, ESG-linked AUM in the US will more than double in size, from US$4.5 trillion in 2021 to US$10.5 trillion in 2026. Sustainability-linked debt will be an important element in expanding ESG exposure.
Combatting greenwashing and making a positive impact
Building on the SLB market’s growth and resilience, however, will not come without its challenges. After the initial wave of enthusiasm for sustainability-linked debt in 2021, investors and lenders have stepped back to assess if issuers are delivering meaningful sustainability and climate outcomes.
Greenwashing—flagged by UN Secretary-General António Guterres as an issue at the COP27 climate change conference in Egypt at the end of 2022—is something investors are scrutinizing, with many anxious to avoid backing SLBs that backtrack on green pledges or indulge in ESG window dressing.
As investors dig into the details of SLB KPIs, it has been noted that some issuers are cherry picking KPIs that are easy to meet, and the penalties for missing those targets are not always material enough for an issuer’s finances. Other issuers have simply excluded elements of their carbon footprint from the scope of the KPIs.
The market, however, has recognized these concerns and taken steps to ensure that sustainability KPIs are meaningful and assessed with rigor. Measures the industry has taken include the requirement for independent, third-party verification of compliance with sustainability KPIs and adherence to the sustainability-linked bond principles compiled by industry body The International Capital Market Association (ICMA).
The ICMA principles are voluntary, but investors are increasingly expecting SLB issuers to comply with the principles to secure financial backing. Investors are also keeping a close eye on how sustainability-linked debt issued during the bull market of the past two years performs against sustainability KPIs when the bonds mature to assess the long-term impact of the instruments.
ESG-focused organizations, including CICERO Shades of Green, ISS and Sustainalytics, are now assigning ratings to ESG-linked debt facilities, with independent certification firms such as Bureau Veritas also checking performance against sustainability performance targets. Audit firms are expected to play a more influential role in the monitoring and reporting of compliance with ESG KPIs in financial disclosures.
Independent oversight is seen as a key step in ensuring not only that issuers deliver on ESG-linked KPIs, but that the KPIs are material and relevant to the issuer’s business operations and industry.
Regulation is also on the horizon, with EU and US watchdogs looking to clamp down on the use of call options—which allow issuers to recall a bond before KPIs are tested—by borrowers to avoid paying higher interest rates if sustainability targets are missed. Advocacy groups are also stepping in, making complaints to regulators when issuers are deemed to have gamed the system.
Certifying that KPI targets are relevant and credible represents a major step in the evolution of SLBs—and will go a long way to ensuring the SLB space fulfills its vast potential.
