Private debt: Sustainable lending set for comeback

It is no surprise that sustainability bonds had a difficult time in 2022. Fixed-income markets nosedived into bear territory for the first time in a generation and these securities were caught in the crossfire. However, the fallout of the war in Ukraine was only partly to blame. Investors were also scrutinising deals much more closely because of concerns over greenwashing. While the outlook is brighter this year, it will take time for the market to develop and mature.

Data from Moody’s Investor Services shows that green, social, sustainability and sustainability linked (GSSS) bonds were not always top of the investment list. Volumes fell 18% in 2022 to $862bn (€920bn) from a record $1.05trn in 2021. 

The sector not only suffered from higher interest rates and inflation, but also from the erosion of the so-called ‘greenium’ effect, which is the lower borrowing cost companies hope to achieve when they issue bonds with a sustainability tag. However, GSSS bonds still fared better than the global bond market, which plummeted 27% last year.

Each segment was impacted differently. Issuance of green bonds, whereby financing is used for projects or activities with positive environmental impact, slipped by 13% to $482bn while social bonds fell 22% to $163bn from 2021. These securities are used to finance or refinance social projects that achieve positive social outcomes, but they suffered as government agencies and corporations cut spending post-pandemic.

The worst-hit segment was sustainability bonds, where issuance declined 24%, followed by sustainability-linked loans (SSLs), which shrank by 23% for the full year. Sustainability bonds are used to finance green and social projects, while SSLs are structurally linked to the issuer’s achievement of climate or broader sustainable development goals (SDGs). 

Sustainability KPIs

Some have questioned these linkages, complaining that the step-up in coupon payments embedded in the bonds’ terms have been too small to motivate issuers to get their ESG house in order. Moreover, environmentally conscious investors do not want to hold debt issued by companies at risk of reneging on their green promises.

Others believe SSLs are a useful tool for change. Joanna Layton, co-head of private credit at Alcentra, says sustainability-linked private loans tend to be considered as loans with margin-adjustment mechanisms or margin rachets tied to ESG criteria.  

She notes that the ESG ratchets are outlined in the loan documentation, and typically consist of a small, but meaningful, margin reduction, which can be around 15bps, offered in response to the business meeting sustainability-related key performance indicators (KPI).  

“The objective is to incentivise and support borrowers to make changes to business practices that improve their sustainability profile,” Layton adds. 

Claire Hedley, ESG director at 17Capital, says: “With increasing issuance there is more scrutiny on the robustness of these instruments in driving progress on sustainability topics; the devil is in the detail of the KPIs to avoid the risk of greenwashing.”

Paul Bail, managing director and head of Europe debt advisory at Baird, says the process is bespoke and formed for the borrower. Usually, loan targets either have multiple sustainable goals or one overarching sustainable goal with different levels of achievement with margins that rise and fall.

Targets may differ but there are often deadlines and fines for not complying. “The time frame is typically between 12 to 18 months and we typically have a penalty if they do not deliver,” says Sonia Rocher, managing director in BlackRock Private Credit Strategies. “If there is no penalty, then it may not make a difference. The metrics, though, are based on a case-by-case basis, but I think going forward there will be more standardisation in how they are structured. There is a lot of work being done in the industry to get a more consistent view.”

Michael Kashani, head of ESG Credit at Apollo, says: “Sustainability linkages can also be made through other means including the call/redemption price, amortisation profile, remediation costs, and fee structure.”

Drivers for growth

Moody’s expects the broad GSSS market to rebound in 2023 to roughly $950bn. However, issuance is likely to remain below 2021’s record $1.05trn volume.  

Moody’s cites the main drivers for growth as mounting pressure on companies to follow through on their decarbonisation commitments, greater policy support for green spending, as well as participation from government issuers. 

Legislation will also be a force, as it promotes greater transparency and standardisation to combat greenwashing. In Europe, this includes the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD).

Market participants are upbeat about the prospects for SSLs.“There is a lot of pressure on asset managers to increase their ESG value proposition, and, as a result, on borrowers to provide ESG data and formalise their ESG strategy,” says Damien Guichard, head of European private credit at Allianz Global Investors. 

“Direct lenders can also have a broad impact and influence on the ESG practices of a company they finance. I see SSLs becoming more prevalent as they are very much in the spirit of Article 8 under SFDR of promoting better ESG practices. In time, we shall also see an expansion of sustainable activities that could be eligible for Article 9.”

17Capital’s Hedley also believes that the flexibility and bespoke nature of SLLs, which allow capital to be used for general corporate purpose rather than ‘use of proceeds’ green bonds that are required to finance green projects, makes them an attractive tool to incentivise borrowers to improve sustainability progress and outcomes.