The sustainability-linked bond market faces growth obstacles as it fails to attract major issuer groups.

Regulatory hurdles, investor skepticism and other challenges mean banks and governments have largely steered clear of sustainability-linked bonds (SLBs) to raise funds, experts said. As a result, widespread adoption of the instrument among these groups is unlikely in the foreseeable future.

Financial services made up just 4.7% of the value of all SLB issuance at the end of 2022, while sovereigns supplied 2.0%, according to S&P Global Ratings analysis. The two issuer groups dominate the market for green bonds and have been a key growth driver in this segment of sustainable debt.

As opposed to green and social bonds, SLBs impose no restrictions on the use of proceeds, but rather link the coupon to the issuer's sustainability performance. This is typically done through a "step-up" mechanism whereby the issuer pays a higher coupon if predefined targets are not met.

"There are some sectors where pickup [of SLBs] will just not be coming in the next few years," said Bram Bos, lead portfolio manager for green, social and impact bonds at Goldman Sachs Asset Management.

Italian energy group Enel SpA issued the first SLB in September 2019, agreeing to a 15-basis-point coupon increase if it missed its renewable energy target. Rapid growth was predicted for the SLB market as the instrument would allow a broader universe of issuers to obtain sustainable financing due to the flexibility in how funds are spent.

While global SLB issuance grew 10-fold in 2021 to $94.38 billion, activity tailed off in 2022 to $70.45 billion, according to S&P Global Ratings.

Higher costs, increased scrutiny

The risk of paying a higher price on debt if a sustainability target is missed is especially challenging for sovereigns, according to 2022 World Bank research. Debt management offices are mandated to raise funds at the lowest possible cost, and some are therefore not willing to accept a potential coupon step-up, it found.

For banks, meanwhile, the regulatory treatment of SLBs is a key reason for the low uptake so far, said Bos. The SLB instrument is currently ineligible for a bank's minimum requirement for own funds and eligible liabilities, or MREL, as the coupon step-up can be considered an incentive to redeem the bond early.

The European Banking Authority in a 2021 report on additional Tier 1 (AT1) instruments raised concern over SLBs, saying that a step-up and/or fees based on missing certain sustainability targets or other performance "should not be allowed or encouraged." The regulator told S&P Global Market intelligence that it is in "continuous dialogue" with stakeholders on possible SLB structures and key performance indicators that could meet its regulatory expectations, but "still many questions remain open."

In credit rating assessments of banks and insurers, SLBs are also not accepted as having equity content, said Dennis Sugrue, global insurance ESG lead at S&P Global Ratings. Such instruments need to be able to absorb losses or conserve cash during times of stress, whereas a step-up coupon could have the opposite effect as it would trigger higher payments to investors, Sugrue said.

Banks and sovereigns often have easier access to use-of-proceeds debt than other issuer groups because of their ability to invest in or finance sustainability projects at scale, said Sugrue. They are therefore likely to continue to prioritize green and social bonds, especially as SLBs face increased scrutiny from the market, he said.

From 2013 to 2022, financial corporates and sovereigns made up 26.4% and 16.4% of global green bond issuance, respectively, according to Climate Bonds Initiative data.

Across industries, SLBs are facing growing skepticism over their impact, credibility and structure. SLBs have "lost their mojo" due to greenwashing accusations and concerns over legal repercussions from including sustainability key performance indicators in their bond documentation, according to Barclays analysts. The lack of a premium on SLBs also makes them less attractive from a cost-saving perspective, Barclays said in a November 2022 note.

Investor concerns over the credibility of SLBs' key performance indicators contributed to the decline in SLB issuance in 2022, said Sugrue. The asset class is now at an "inflection point," he said, adding that investor demand will continue to wane if such worries are not addressed.

Moody's said in a January report it expects about $75 billion of sustainability-linked bonds to be issued globally in 2023, a small uptick from last year, though it noted that prospective issuers "may be reluctant to enter a market where increased scrutiny could expose them to reputational damage."

Reinforcing commitments

While widespread adoption of SLBs among banks and sovereigns is unlikely in the foreseeable future, some may still embrace the instrument as they seek to reinforce their sustainability commitments.

Chile was the first sovereign to issue an SLB in March 2022, with a 20-year, $2 billion bond. Uruguay followed in October. The simplicity and flexibility of SLBs could appeal to more emerging market sovereigns that may find it more difficult to meet the reporting requirements for use-of-proceeds bonds, said Sugrue.

In a World Bank survey of 28 emerging market sovereigns conducted last year, six said they were considering sustainability-linked bonds, although more respondents expressed interest in use-of-proceeds debt, such as green and social bonds.

In the financial space, Berlin Hyp AG in 2021 was the first bank to issue an SLB. It allowed the bank to share its decarbonization plans and progress with market participants and demonstrate its commitment to reaching its target, said Bodo Winkler-Viti, head of funding and investor relations.

Another advantage of the SLB it that is takes a "more holistic approach" because it relates to the whole organization and not a single portfolio, he said. Berlin Hyp worked around the regulatory question by selecting the senior preferred format and stating that the deal will not be MREL eligible, according to Winkler-Viti.

Investor cautiousness

Many investors, however, remain cautious. Sovereign SLBs are a more complex investment than use-of-proceeds bonds because a change of government could jeopardize sustainability targets set under SLBs with a longer maturity, said Alban de Faÿ, social responsible investment portfolio manager at Amundi. This has been a particular concern for emerging markets, de Faÿ said.

Amundi has also had discussions with banks on potential alternatives to the step-up mechanism, but this feature is crucial for investors in an SLB, de Faÿ said, as it compensates for any financial loss they may face when an issuer misses a target.

Better data and uptake of transition plans among corporate customers will ultimately be crucial for banks before they put annual emissions goals into a sustainability-linked bond, said Jacob Michaelsen, head of sustainable finance advisory at Nordea Markets. A big challenge for banks is that most of their carbon footprint resides in their lending book, meaning that banks do not own the assets that need to transition, he said.

"Until we feel we have sufficient confidence in the general adoption of science-based targets at the corporate level and the underlying quality of that data, it will still represent a challenge for banks to get comfort around their own target and, ultimately, their willingness to bring those own targets into their issuance," Michaelsen said.