Sustainability

Strange bedfellows? The challenges of a Sustainability Linked Bond and Sustainability Linked Loan combined framework

Amidst the rapid growth of the Sustainability Linked Bond (SLB) market, more companies are considering finding one “home” for all their sustainability linked debt instruments. This allows for a unified approach to investors and can create synergies in structuring such instruments.

Looking at the number of Key Performance Indicators (KPIs), on average the reviewed frameworks included two KPIs. This is arguably more in line with bond market practice, where using one or two KPIs is the norm, with loan transactions often based on three or more KPIs. It could suggest that not all loan KPIs have been included in the framework. This would perhaps not be surprising: Sustainability Linked Loans (SLL) are generally executed with relationship banks and hence there is often a greater understanding and ability to include KPIs that are more tailored to the borrower and outside of market precedents.

In terms of target tenor, nearly half of the frameworks researched included two targets: one within 5-7 years and a second longer-term target of around 9 years (typically 2030). Such longer-dated targets typically lend themselves better to bonds than to SLLs, noting the shorter tenor of these instruments (typically 3-5 years).

Instead, SLLs include annualised targets throughout the term of the facility which also supports the application of the sustainability discount / premium to the margin. However, only three of the frameworks reviewed included annualised targets [3].

In terms of instrument mechanics (such as the coupon or margin adjustment), framework disclosure is limited across both the bond and loan application. In a majority of frameworks, such information is broadly worded, with the detail around both bond and loan mechanics referenced as “in the relevant transaction documentation”. 

There are various plausible explanations for relatively better disclosure around SLB application:
  • Simplicity: Adding more KPIs and target years can make the document more complex and, potentially, less understandable. This also applies to the associated Second Party Opinion process (which all of the frameworks we observed obtained)
  • Longevity of framework: Adding annualised targets will likely reduce the shelf life of a framework, noting these are more likely to require updates
  • Maintaining confidentiality: The economic terms and conditions of loans (particularly in Europe) are not publicly accessible, noting it’s a private market
  • Avoiding scrutiny: Companies may be concerned that some of the KPIs agreed in a private loan contract won’t be understood or well received by external stakeholders
  • Segmentation of KPIs: Certain SLL KPIs, such as ESG ratings, are considered unsuitable for an SLB (albeit such distinction can be drawn in the framework)
  • Confidence: Long-term targets enable greater variability in performance within interim years. Annual targets typically require incremental year-on-year improvements, and some issuers may be concerned with the reputational impact of not meeting their annual targets if made public

It is plausible that the sustainability linked frameworks become more all-encompassing in the future. Regulators and investors alike are becoming more interested in understanding the sustainability features of financial instruments. For now though, the combination of an SLB and SLL framework remains – for understandable reasons – an unequal partnership.

Thank you to Aaron Farr for the helpful research assistance.

Notes

[1] Research based on analysis of 30 Financing Frameworks that include alignment to the Loan Market Association (LMA) Sustainability Linked Loan (or LMA equivalent) and International Capital Market Association Sustainability Linked Bond Principles. Frameworks were all published in 2020 and 2021. The sample is international with the majority based in Europe and the United Kingdom.

[2] Frameworks and Second Party Opinions (SPOs) are not mandatory in either the bond or the loan market, however, in the bond market they’re deemed best practice, and the large majority of bond issuers obtain them.

[3] Annualised targets are not explicitly required in the Loan Market Association Sustainability Linked Loan Principles but are commonplace and a key component.

 

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