- Sustainability-linked bonds have reached the US high-yield market, with $1.4 billion raised in 2021.
- Interest payments on these bonds can fluctuate based on ESG-linked performance targets.
- Investors appreciate the sentiment, but question the sincerity of such ESG initiatives.
- See more stories on Insider’s business page.
It’s been a long time coming, but sustainable financing initiatives have finally ventured down the credit spectrum into the US high-yield bond market.
More borrowers today are held accountable by investors that value companies that portray themselves as better corporate citizens.
And with investors allocating large sums of cash to sustainable investments, borrowers can leverage this demand for ESG-linked debt to diversify their investor base and, most importantly, obtain the cheapest possible source of capital.
Aluminum products producer Constellium raised a $500 million sustainability-linked bond (SLB) last month, only the second to do so in the US high-yield market. The first SLB was a $900 million transaction for an issuer called Level 3 Financing, a subsidiary of data technology company Lumen Technologies, done a month earlier.
SLBs are tied to metrics the company promises its investors that it will adhere to or exceed. Constellium, for example, intends to reduce greenhouse gases and increase its recycled aluminum work.
Unlike green or social bonds, SLBs are not married to a strict use of proceeds where the funds must be ring-fenced for a specific project, such as a wind farm or to fund efforts to hire more women or people from minority groups, for example.
Importantly, interest payments on SLBs can increase throughout the life of the bond if the borrower fails to meet stated goals related to carbon emissions or social and governance policies.
While investors have applauded the introduction of these debt instruments, some are skeptical about the sincerity of SLBs because they are not held to the same strict standards as green bonds.
“In many cases, these targets have no teeth,” James Rich, senior portfolio manager of sustainable fixed income at Aegon Asset Management said. “If they’re serious about transitioning to greener policies, then [companies] should be willing to give investors a higher coupon, where there is a material cost if they don’t meet their targets.”
Cheap debt versus meaningful change
Constellium’s $500 million bond matures in 2029 and pays an interest rate, or coupon, of 3.75%.
The company intends to reduce greenhouse gases by 25% before the end of 2025 versus its 2015 numbers, according to a February 9 report from Moody’s. Constellium has also pledged to increase its recycled aluminum work to 685,000 metric tons by the end of 2026, a 10% increase from 2019.
The coupon will increase by just 0.125% in 2026 if the greenhouse gas reductions target is not met and a further 0.125% in 2027 if Constellium fails to boost its recycled aluminum works to the set level.
“We’ve got to see progress before we are going to believe it, so tying your borrowing rate to ESG targets makes sense to us,” said John McClain, a portfolio manager at Diamond Hill Capital Management.
Aegon’s Rich, meanwhile, is skeptical whether investors will actually be recouping interest payments on the aluminum company’s bonds in 2026 and 2027, regardless of the potential increase in coupon payments.
The bond is due in 2029, but Constellium can repay bondholders in full after three years in 2024, according to a banker familiar with the deal.
This process, known as callability, also enables Constellium to raise a new bond in 2024 – if market conditions are favorable – and repay holders of its existing securities with the new transaction that may be procured with a cheaper coupon. It is also at the borrower’s discretion whether it will maintain these ESG metrics through another SLB, or by simply issuing a regular high-yield bond.
“Issuers will put these pie-in-the-sky targets so far out into the future, but these bonds can get called away after a few years if, like today’s market, there is low yield and low interest rates,” said Rich. “I’d like to see an SLB with a target set for every year.”
A work in progress
Nonetheless, SLBs in the high-yield market are, seemingly, the next stage in the evolution of ESG in the capital markets.
Fund managers want to put their money to work on sustainable initiatives throughout the entire credit spectrum.
“US high-yield is the last place to start picking this up and I think it’s going to be a theme,” said Mason Parker, a managing director in leveraged finance at Deutsche Bank, which led the deal for Constellium.
“Management teams are seeing the opportunity more strategically, and the idea that by issuing sustainability-linked bonds and aligning their financing with their sustainability targets, they can differentiate themselves from their peers.”
Indeed, as more fund managers prioritize sustainable investments, companies that do the work to determine ways to improve their ESG metrics will be rewarded with access to a broader investor base and more options in the capital markets.
“We’re in the early innings of seeing what this looks like,” said McClain. “The targets might not be the highest hurdles, but it is a signal that a company is taking a real look at improving its ESG rating.”