Project-Based Structures
Green bonds are still the biggest class of ESG-linked finance, with more than US$1 trillion outstanding, according to the Climate Bonds Initiative. Proceeds for each issue are meant to finance a green project (or range of projects) with an environmentally beneficial purpose and in line with a specified framework and timeline. This structure is appealing for investors seeking a clear link between capital investment and improving the environment.
Social bonds work the same way as green bonds but finance socially impactful projects. Examples include new buildings for communal benefit, educational programs for an underprivileged demographic and more hospital beds for low-income areas.
Other project-based structures include sustainability bonds and sustainable development goal (SDG) bonds. Proceeds for sustainability bonds can fund both social and environmental initiatives; for SDG bonds, the pool of eligible assets can be wider and align with one or more of the United Nations Sustainable Development Goals (UNSDGs).
Target-Based Structures
Fostering a more sustainable world requires broad improvements in business behaviour. Enter the sustainability-linked bond, a recent innovation offering a target-based structure that incorporates key performance indicators (KPIs). Its goal is to achieve higher ESG standards across a company, rather than to finance a specific project. If the bond issuer fails to hit specified targets as measured by the KPIs, investors are compensated by receiving higher interest payments under the bond’s terms.
Investors with a responsibility focus will find that this bond structure makes the issuing company accountable for executing on a top-down strategy that materially improves the sustainability of the business. It’s a much broader scope than identifying and segregating a set of green assets for ESG-positive projects while possibly continuing with business as usual for other activities.
Investors Must Be Choosy About ESG-Labeled Issues
As new ESG-labeled issues proliferate, it’s critical that investors use a disciplined framework to evaluate them. We believe that bonds whose terms merely gesture toward environmental and social factors but have no real impact are less likely to perform well over the long term—making a bond’s design as important as its price.
The first test bond investors must apply is materiality: Is the use of proceeds for a green bond significant to the issuer’s business and industry? Does the KPI target for a sustainability-linked bond represent a material improvement for the entire firm? We’ve noted instances where use of proceeds or KPIs covered only tiny parts of a company. By contrast, Faurecia’s Green Notes issue was aligned with the firm’s core mission of sustainable mobility, and its use of proceeds supports the company’s ambition to diversify into hydrogen-powered transport.
Green bond issuers should also provide a green bond framework and corporate plan, together with basic firmwide commitments, such as adopting a transition pathway in line with 1.5 degrees warming or aiming for net-zero carbon output on most relevant scopes (for most industries, that includes scope 3).
Sustainability-linked structures that lack ambitious objectives are generally unattractive. Some KPI targets are overly generic and disappointingly modest. In these cases, investors need to press for specific goals and stretch KPIs, such as Rexel’s. The company’s KPIs are specific, set readily measurable goals across the whole business, include scope 3 emissions and feature some timelines as short as three years.
It’s also important to consider both the timeline of the KPIs and the penalty for non-performance if targets are not met. Investors need to scrutinize whether the coupon step-up, with its higher income, is adequate compensation for the company missing its target, and whether they will receive enough of the higher coupon payments before the KPI timeline expires. Too many structures currently feature limited step-ups with back-ended penalties that require minimal additional interest payments. If investors want to achieve a green future, they must push back against easy structures and limited repercussions.
AB’s Portfolios with Purpose
We believe that green and other ESG-labeled bonds will play a very important part in creating a greener and better future. That’s why they are a key component of the bond portfolios in our responsible investing fund ranges,* which we call Portfolios with Purpose.
These fund ranges include our Sustainable platform which invests in bonds issued by companies whose products and services contribute to achieving key components of the UNSDGs, investing at least 80% of their assets in bonds that we believe are positively aligned with the UNSDGs and at least 15% in ESG-labeled bonds (20% in the case of our Sustainable Global Thematic Credit Portfolio). Our Portfolios with Purpose portfolio management team use a proprietary process to analyse ESG-labeled bonds, including their use of proceeds and environmental and social impact. The team also engages with issuers to assess their progress and behaviours.
ESG-labeled bonds can help make a greener future a reality. But investors need to play their part. By carefully analysing each bond’s structure, scrutinizing its objectives, insisting on material and ambitious goals, and engaging with company management and their bankers to press for progress, investors can ensure their financing can make a real difference.
