WHEN the first sustainability-linked bond (SLBs) was launched in 2019 by Italian gas and electricity manufacturer Enel, it was touted as the future for sustainability investing.

Unlike use-of-proceeds bonds such as green, social and sustainability bonds, issuers of SLBs are not compelled to channel all the proceeds to pre-defined green or social projects; instead, they have the flexibility to use the funds as they please and set their own sustainability targets.

This was of particular appeal for companies in hard-to-abate sectors that typically cannot issue green bonds.

This new sustainable debt instrument soon became popular among issuers, with as much as US$29.4 billion in proceeds raised globally in the first quarter of 2022, according to data from Refinitiv.

While SLBs did not catch on in popularity in this region relative to the global market, there were still a handful of issuances in 2021 and 2022, with over US$1.2 billion raised in the last quarter of 2021 alone.

Fast-forward to 2023: The issuance volumes of SLB have dropped drastically to US$9.7 billion globally in the third quarter.

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The SLB market is even more dismal in South-east Asia; only one issuance has been made so far this year, with that happening in the second quarter, at US$6.8 million.

The decline in proceeds raised from SLBs needs to be looked at in the wider context of the overall contraction in global bond issuances amid a rising-rate environment.

Sustainable bond proceeds went down for the first time in 2022. It was a 21 per cent drop to US$692 billion from the previous year, according to data from Dealogic. However, this was a slower decline than the one in the overall bond market, where the bond supply fell 30 per cent to US$6.3 trillion over the same period.

Nonetheless, the fall among SLBs was still more than that for use-of-proceeds ESG bonds. Green bonds are still the most popular form of sustainable debt, accounting for close to 60 per cent of all sustainable-bond proceeds in the third quarter of 2023.

There are a couple of reasons for green bonds’ staying power: Firstly, use-of-proceeds bonds have been around longer and are more-established debt structures.

Secondly, SLB issuers are subjected to an additional contingent liability that does not exist with use-of-proceeds bonds. This is because there is a rate step-up mechanism built into their structure, under which issuers who fail to meet their sustainability performance targets have to pay a higher coupon rate to their bondholders.

How these sustainability performance targets are set is also increasingly being scrutinised amid potential greenwashing allegations. This is especially so for SLBs issued in the European Union, where investors are asking how appropriate it is for debt structures without pre-defined green or social objectives to be classified under Article 9 of the EU’s Sustainable Finance Disclosures Regulation, which has more stringent criteria for what constitutes a sustainable investment.

This is not to say that the sustainability-linked mechanism no longer serves the need of companies.

While fewer SLBs are now being issued, sustainability-linked loans (SLL) are still doing pretty well, considering the higher costs of financing companies are facing.

In South-east Asia, proceeds from SLLs for the third quarter of this year have fallen by 42.5 per cent to US$4.9 billion from proceeds for the same period a year ago; however, the cumulative amount raised over the first three quarters of 2023 is actually higher than in the corresponding period in the year before (US$15.5 billion against US$11.9 billion in the year before).

As is the case for SLBs, SLL issuers are subjected to interest-rate changes, depending on whether they managed to meet their pre-determined sustainability performance targets. The difference, though, is that SLL issuers get lower rates of financing from banks when they meet their targets.

SLBs typically contain only that step-up mechanism, which means their issuers are handed a punitive interest rate for missing their targets – but get nothing in return for meeting them.

In other words, SLLs are subsidy-driven, and SLBs are penalty-focused.

SLLs are also typically easier to structure than SLBs. For one, as SLLs are deals between corporates and banks, corporates may enjoy lower costs of financing based on their prior client relationship with the bank. SLB issuers do not have this kind of relationship to tap into when they raise funds from investors.

There is also greater flexibility in how SLLs are structured, with the terms varying among the banks. SLBs, on the other hand, come with a more standard template, given a certain level of market expectation; this typically makes issuing SLBs a more-expensive exercise, as sustainability consultants need to be hired.

And, given that SLLs tend to have shorter tenors, the target-setting exercise is less complicated than for SLBs, which often entail multi-year target setting; questions also have to be fielded on the ambition of these targets.

Furthermore, terms of SLLs are usually confidential, which means that issuers can avoid public scrutiny of their targets. SLB terms, in contrast, are public.

With interest rates expected to peak soon and start tapering next year, corporates would prefer floating rates over issuing a bond, under which the issuer has to pay a fixed coupon rate for the duration of the tenor.

For these reasons, some investment bankers have observed some large corporates in Singapore moving from bonds to loans in general, whether or not a sustainability-linked mechanism is bundled with the deal.

However, for large corporates that typically tend to raise larger sums of money, there is a limit to how much they can borrow from banks because of regulations that limit the amount a bank can lend to a client.

This turn to the bank market to raise money should therefore be just a stopgap measure, at least until rates stabilise, and not a long-term solution for companies’ financing needs.