Market players demanding changes to sustainability-linked bonds: abrdn

SUSTAINABILITY-linked bond (SLB) structures may shift in the future as debt market participants increasingly question the way performance targets are enforced and proceeds are used, said Henry Loh, head of Asian credit at asset manager abrdn.

The sustainability-linked mechanism rewards or penalises a borrower depending on the borrower’s performance against key performance indicators (KPIs). That is typically done by adjusting the interest on sustainability-linked debt; for example, the coupon on a five-year SLB might step up in the second year if a borrower fails to achieve an emissions reduction target on time.

However, such a penalty structure means that holders of the SLB stand to benefit economically if the borrower underperforms on the sustainability targets, creating an ethical dilemma for investors, Loh said.

In response, Loh said, some SLBs are now structured in a way where issuers that fail to hit their targets are required to purchase carbon offsets instead of paying a higher interest rate. Such a solution would increase the financing cost for an underperforming borrower without enriching investors.

“Not a great outcome, but certainly better than, then, maybe rewarding investors,” Loh said at a media conference on Thursday (May 25).

“People are really examining structures in terms of rationales and logic. Does it implicitly make sense for an investor who wants to drive change to be rewarded when a company does not hit their KPI? Does that logically tie in with what we’re trying to achieve?” he added.

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Another criticism lies with the size of the step-up penalty. Thus far, the market has generally converged towards a step-up rate of 25 basis points (bps), an amount that has been panned as too little. 

“If you’re a company that’s funding at 7 per cent, a 25 bps increase in your coupon for one year means nothing,” Loh said. 

The ambition of targets can also present problems. Loh mentioned an example of an issuer whose sustainability KPI would require capital expenditure that was “a drop in the ocean” compared to the company’s overall capital expenditure. 

Given that there is still very strong demand for labelled bonds in Asia among fixed income investors, Loh believed that there is scope for SLB development and opportunities to explore how new SLB structures could look like.

Opportunities for investors

Beyond SLB structures, Loh saw investment opportunities in companies that have poor environmental, social and governance (ESG) ratings, but have the potential to better its ratings.

Focusing on top-rated ESG companies would mean that fixed-income investors are buying more expensive companies and missing out on the opportunity for spread compression from borrowers’ improving ESG ratings, Loh noted.

“In Asia, because of this data inefficiency, because of this data asymmetry, that opportunity exists,” he added.

Loh said that one way abrdn identifies investable companies that are poorly rated is to speak with the companies directly, coupled with conducting their own due diligence and data verification.

Beyond fixed income, David Smith, senior investment director for Asian equities at abrdn, noted opportunities in digital healthcare and electric vehicles (EVs) in South-east Asian markets.

Two factors supporting these areas are that they have reached strong technological thresholds and have government support. 

Access to healthcare among citizens of the Association of Southeast Asian Nations (Asean) member states is relatively low. Governments in Asean, such as Indonesia, are significantly increasing their spending on healthcare, including national insurance scheme initiatives.

In the case of EVs, the shares of sales is currently 9 per cent for cars, and 1 per cent for vans and trucks. With governments in this region setting policies to phase out the sale of internal combustion engines, Smith said that the EV market here is about to reach a period of massive maturity where there will be mass adoption.

This will not only transform supply chains, but bring about new opportunities for investors around EV manufacturers, battery manufacturers, software providers and charging infrastructure.

The developing status of many Asian markets mean that they are relatively unencumbered by legacy infrastructure, Smith explained. This raises the potential to develop and implement technology, structures and policies in a cost-effective way.

“What’s interesting about Asia is that Asia has the opportunity to be a fast follower,” he said.

Smith also noted that abrdn is interested in India, given government support for decarbonisation, and regulatory framework around its grid system.

“Almost all incremental demand over the next nine years will be met from low carbon or renewable energy provision,” he said.

While equipment for renewable energy production has historically been made in China, India has introduced incentive schemes to develop this ecosystem domestically. 

Smith also believes that valuations in the ESG sector have somewhat corrected, due to interest rate hikes, from how much they were stretched in 2020 and 2021 as a result of the exponential increase in interest towards sustainability.

There are less concerns of a bubble than two years ago, with more attractive valuations and stronger fundamentals in the form of government policy.

Nonetheless, he noted that valuations are still more stretched in the energy transition part of the market.