Banks are exploring innovative sustainable bond structures as they seek to expand their issuance capacity beyond the traditional green bond and capitalize on investor demand.

Financial institutions have been major issuers of green bonds to date, helping them to fund loans for activities such as renewable energy and electric cars while underscoring their own sustainability commitments. The volume of loans that can underpin these bonds is diminishing, however, and regulatory concerns mean other established alternative products, such as sustainability-linked bonds, are unsuitable for banks.

A key challenge for banks is that most of their carbon footprint resides in their lending book, meaning banks do not own the assets that need to transition, said Jacob Michaelsen, head of sustainable finance advisory at Nordea Markets. New financing structures will therefore be needed, he said.

"We need to see innovation in the market, as we did in the first place with the green bond and sustainability-linked loans," Michaelsen said.

Analysts expect bank issuance of social bonds and instruments linked to transitional activities to grow.

Finland-headquartered Nordea Bank Abp in September 2022 sold a use-of-proceeds bond to finance its sustainability-linked loan portfolio, the first of its kind. Nordea Markets, the bank's advisory unit, is in conversation with several other financial institutions about issuing a similar structure.

"We've received very strong support from investors and generally from the market participants," Michaelsen said.

While issuers in other industries have adopted the sustainability-linked bond as a means to support their own transition, financial institutions have largely steered clear of this instrument due to regulatory barriers and investor concerns. Nordea's hybrid bond instead offered a use-of-proceed structure — similar to that of green and social bonds — that issuers, investors and regulators are comfortable with, while the proceeds help to finance polluting companies that are in transition, Michaelsen said.

UK-based lender NatWest Group PLC in March issued a social bond that will finance loans to women-led enterprises, the first gender-focused bond from a European bank. The issuance raised €500 million from an order book of more than €1.75 billion at its peak.

"There was very strong investor demand," said Scott Forrest, head of NatWest's treasury debt capital markets. "We had a lot of interest and support because it was something slightly different. We saw a number of names in our order book that we'd not seen before."

NatWest has seen growing investor interest in social bonds since its first issuance in 2019 as more funds have expanded their mandate to include social investments, Forrest said. This diversification of its investor base is a key benefit of issuing sustainable bonds, Forrest said.

The bank has issued three green and three social bonds to date and has set a target to raise about £1 billion of its annual senior debt issuance in the green or social bond format.

Green bond slowdown

The financial sector has been a key driver of growth in green bond supply to date, making up 26.4% of total global issuance between 2013 and 2022, according to data from the Climate Bonds Initiative.

In 2022, banks issued a record €59.9 billion in euro-denominated green bonds, up from €46.4 billion in 2021 and €18.6 billion in 2020, according to ING research. But growth may lose steam as financial institutions face boundaries to the number of existing loans they can tag as green, while new lending growth is anticipated to slow, said Maureen Schuller, head of financials sector strategy at ING. She anticipates that bank euro green bond issuance will drop to €45 billion in 2023, despite banks' increasing funding needs.

Meanwhile, investor demand for sustainable investment alternatives "will remain disproportionally high" due to regulation and investors' own sustainability ambitions, said Schuller. This will incentivize banks to expand their sustainable bond frameworks to cover new asset types while offering new types of bonds, she said.

Schuller expects that more banks will find Nordea's hybrid structure appealing to enable investors to contribute to clients' transition efforts. The development of an EU taxonomy for significantly harmful activities will likely also present new opportunities for banks, Schuller said. Transition bonds, for example, could help fund the decarbonization of polluting industries.

S&P Global Ratings expects that banks will increasingly embrace social debt issuance as they explore ways to secure financing that can support lending to underserved segments of the population. Dennis Sugrue, global insurance environmental, social and governance lead at S&P Global Ratings, projects a "substantial growth" in so-called sustainability bonds, which combine green and social assets, from banks in 2023.

Receptive investor base

NatWest is engaging with investors on sustainability topics and has "a very receptive investor base," Forrest said. The bank is evolving its approach to sustainable bond impact reporting and structure through these conversations. For one thing, the British lender has identified an investor preference for using survey responses from customers to demonstrate the impact of the bond, which the bank will look to implement next year, Forrest said.

For future issuances, NatWest will also look to discuss with investors the time period for allocating new assets to a bond, which is traditionally 12 months. Extending this to match the tenor of the bond could allow the bank to include more new lending in its sustainable bonds. NatWest's first two green bonds were dedicated to 100% refinancing of existing loans, while more recent bond proceeds have in part been allocated to new lending.

"The door is open and sometimes you just have to go up to investors and have those conversations," Forrest said.