ESG Managers to High-Yield Issuers: Don’t Stand Still

Environmental, social and governance (ESG)-linked bond structures have become very popular in investment-grade bond markets. We think the time is right for high-yield issuers to join in. For investors, that will create both new opportunities and analytical challenges.

ESG-linked bond structures have come a long way. From just US$243 million of green bonds issued cumulatively in March 2016, there were US$1.8 trillion of bonds cumulatively issued as of March 30, 2021, across a wide spectrum of green and other ESG-linked structures. But so far, the issuance has come mostly from investment-grade companies. That’s not surprising, because it takes scale to launch a project-based green, social or sustainability bond. For these categories, companies must identify a specific project large enough to warrant a dedicated bond issue.

Target-Based Structures Create New Opportunities—and Challenges

Even so, small and mid-sized high-yield companies need not be excluded from ESG-linked bond markets. A relatively new target-based ESG bond structure enables companies to issue bonds linked to specific firm-wide ESG improvement objectives. In this part of the market, companies can issue key performance indicator (KPI)-linked bonds whose performance targets can be tailored to their specific industry and circumstances. We believe this development creates an opportunity for high-yield companies—particularly those in “dirty” industries—to finance their transition to a sustainable business model.

To access this market, high-yield companies don’t need to commit to a specific capex project or projects. Instead, they need first to demonstrate strong sustainability credentials, and then to deliver on their sustainability commitments.

Because high-yield markets contain a high proportion of “old economy” businesses in manufacturing and extractive industries, target-based ESG structures could be attractive for a wide range of issuers. Cement or metal manufacturing companies could, for instance, access finance linked to a carbon-reduction plan using science-based targets compatible with a 1.5 degrees warming scenario.

But because KPI-linked bonds can provide an easy access point to new financing, and because their terms can be highly issuer-specific and varied, they can also present a higher risk of greenwashing. The challenge for investors is to discriminate between those issuers with a sound sustainability plan and a strong commitment to execute it, and those with a merely opportunistic approach.