Banking on sustainability-linked bonds
Banks, despite being a leader in sustainable bond issuance overall, have been strangely absent from the list of sustainability-linked bond (SLB) issuers.
SLBs are a recent and growing trend, with year-to-date issuance across the entire corporate market for 2021 already at $13.2 billion (including $2 billion from banks, as shown as Figure 2), surpassing the 2020 total of $8.5 billion. The key feature of SLBs is that they do not tie the issuer to specific projects, but instead focus on strategic sustainability and ESG objectives at the company level. This gives issuers more flexibility regarding how the proceeds are used.
Taking the plunge
Berlin Hyp* recently became the first bank to issue an SLB, followed shortly by China Construction Bank (CCB)*. Looking closely, we think there are some features worth highlighting. First, the key performance indicators for ESG progress used by these issuers reference the entire loan portfolio (Berlin Hyp is targeting carbon-intensity reductions, whilst CCB is targeting the percentage of green loans). Second, both frameworks utilise sustainability performance targets with coupon step-ups, should they fail to achieve these targets at specified observation dates. And finally, the SLBs issued have been senior debt.
Can banks step up?
The market for SLBs has so far converged on the use of ‘step-up’ coupons. But the use of step-ups conflicts with regulatory constraints around incentives to redeem securities: under Basel III, coupon step-ups are not allowed. For example, if a bank thought it was unlikely to meet its ESG KPI targets (meaning that a step-up in the SLB coupon would be triggered), this could incentivise the bank to call the bond, which would in turn weaken its capital position. For banks looking to issue structured SLBs in capital formats, this is a significant hurdle to clear.
There are two ways in which we think banks could overcome this challenge:
1. By amending the structure of the bonds: there is sufficient flexibility in the ICMA Sustainability Linked Bond Principles to move away from coupon step-ups. However, it is uncertain whether the market would accept alternatives (e.g. step-downs, or a bullet payment at maturity), so the new challenge here would be to improve the alignment between investors and issuers; or
2. By issuing more SLBs at a more senior level in the capital structure (i.e. senior preferred debt): this would, however, be subject to funding requirements, which could limit the scope for issuance.
SLBs versus use-of-proceeds bonds?
Through their link to firm-level ESG targets, SLBs could provide a meaningful way for banks to demonstrate their overall direction of travel on sustainability matters. Whilst use-of-proceeds (‘UOP’) bonds give detailed information on specific projects and their impacts, they do not necessarily align clearly to the strategic objectives of the issuer in the way that SLBs do. For example, it is not clear how the co-existence of individual ‘green projects’ (funded by UOP bonds) and ‘brown projects’ is compatible with achieving a bank’s overall sustainability objectives.
As demonstrated in Figures 3 and 4, LGIM analysis and estimates show that, despite being one the largest issuing sectors, at the bank level UOP bond issuance remains very low relative to the size of overall loan books.
There are numerous reasons for this, but one important obstacle is the availability of projects to fund. Given that SLBs do not depend on particular projects being available, we think that – subject to overcoming the hurdles mentioned above – banks may find that they are a more flexible alternative to UOP bonds.
It’s what’s inside that counts
Regardless of the ‘label’ on a bond, we subject all of our fixed income investments to the same level of scrutiny from a valuation perspective. Whether they issue SLBs or not, we believe that banks should have a robust climate (and broader sustainability) strategy in place.
We see a significant opportunity for issuers to demonstrate their ESG ambitions and credentials to the market by having clear targets; SLBs are just one tool that could help them do this. We will be watching to see whether they increase their SLB issuance in the future, or whether they choose or create an alternative.
*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.
 Source: Bloomberg, May 2021
 This is not applicable to senior bonds, which are ‘funding’ instruments rather than ‘capital’ instruments – as above, the SLBs issued by banks so far have been senior debt.