Could SLLBs fix sustainability-linked lending’s problems?

Nordea Bank brought its innovative sustainability-linked loan bond (SLLB) in euros to the market at the end of August. It was the second issuance under its sustainability-linked loan funding framework, which the bank has taken pains to stress involves the issue of neither green bonds nor sustainability-linked bonds but something different: a standard use-of-proceeds bond to fund a portfolio of sustainability-linked loans (SLLs).

The August issuance followed a debut under the framework in September 2022. The August deal was the first issuance in euros, the earlier transaction had been a dual-tranche Swedish krona and Norwegian krone deal. The euro deal was much larger – raising €1 billion – where the previous issuances had raised a total of $370 million, with a three-year SKr2.8 billion ($260 million) tranche and a five-year NKr1.2 billion ($110 million).

The Nordea team spent more than two years developing the framework to "advance the market for sustainable finance by providing an opportunity for investors to support companies that have set material and ambitious goals", driving more liquidity towards these products.

SLLs must meet certain eligibility requirements under the framework. These include that they must be aligned with sustainability-linked loan principles (such as those by the Loan Market Association) as of the year the facility was signed; they must make a positive contribution to the bank’s climate change mitigation impact objectives; and they must have key performance indicators that are considered ‘material’ and sustainable performance targets that are ‘ambitious’, as assessed by an external reviewer.

The euro deal was designed to tap into a wider investor base, a goal that the bank has clearly achieved.

The 2022 deal saw investors from only Sweden and Norway, while the euro issuance has seen investors come in from France (35%); the UK and Ireland (13%); Benelux (12%); Germany, Austria and Switzerland (11%); southern Europe (10%); Asia (8%); the Nordics (5%); and elsewhere (6%). It was also oversubscribed, with an order book of €1.95 billion.

Nordea is not the first bank to issue a bond to finance its SLL portfolio. In November 2021, Bank of China issued a similar structure from its London branch, described as a sustainability re-linked bond.

But there is a key difference between the two, which is how likely the structure is to be picked up by FIG issuers.

BoC’s $300 million three-year bond had a base coupon of 1% and included a coupon adjustment rate determined by the aggregate margin adjustments on the underlying SLL portfolio. In other words, the coupon adjustment for the SLL borrowers against their KPIs would be passed on to bondholders.

In Nordea’s framework, there is no coupon adjustment for investors. Instead, the bank absorbs the coupon adjustment from the SLL portfolio and offers investors a set rate. This ensures the bond adheres to minimum requirement for own funds and eligible liabilities (MREL) and total loss-absorbing capacity (TLAC) regulatory capital requirements.

“A potential step-up coupon or redemption could be viewed as an incentive to redeem the bond earlier by the regulator and would then not be allowed in our MREL requirements,” says Petra Mellor, head of bank debt, chief treasury manager at Nordea. “MREL eligibility is an important part of the structure for us.”

Coupon adjustment and its impact on eligibility as regulatory capital is a key reason why financial institutions do not often offer sustainability-linked bonds.

Nordea's framework is attractive, therefore, because it offers exposure to the sustainability-linked market for FIG investors, who can find issuance scarce in a market more commonly tapped by corporates and sovereigns and supranational agencies.

But the real gamechanger is that the structure is an opportunity to add a layer of scrutiny and accountability to the SLL market – a market that was designed to address the need for companies to transition to net zero and make progress in other areas related to sustainability but has more recently struggled with accusations of greenwashing and a lack of transparency.

The SLL market has grown quickly. In 2019, 88 SLLs were issued, with a total volume of $87.36 billion; in 2022, 542 SLLs were issued, with a total volume of $458.96 billion, according to Dealogic.

The geographic spread has also expanded considerably, with regions such as the Middle East starting to take up the product. In 2019, 69% of the SLLs were issued in Europe, whereas in 2022, European SLLs made up only 38% of the global market.

“The problem with SLLs is that sustainability-linked does not mean the same thing as sustainable,” says Josephine Richardson, head of research at Anthropocene Fixed Income Institute (AFII), a sustainable finance think tank. “But banks often want it to.”

Notably in June, the UK’s Financial Conduct Authority released a letter to bank heads of environmental, social and governance, and sustainable finance raising concerns about the materiality and ambition of the KPIs used in the loans.

The FCA is concerned about weak incentives, potential conflicts of interest and suggestions of low ambition and poor design in some SLLs’ SPTs and KPIs.

“Banks typically count SLLs towards their sustainable financing targets,” the letter noted. "However, a number of firms we spoke to indicated that the classification of SLLs varies considerably between banks. One firm considered that of 250 SLL transactions completed in 2022, only 30% were deemed ‘fit for purpose’, and that in 50% of cases, KPIs were not robust."

As Euromoney has discussed previously, part of the issue is that the market has not evolved to ensure that step-ups or step-downs are impactful for borrowers.

The FCA noted that there had been no observable increase in step-ups despite the changes to the global interest-rate environment.

Another criticism from the regulator was of the conflict between a bank looking to manage its relationship with a borrower while still ensuring strong sustainability credentials. In some cases, banks were incentivised to achieve ESG financing targets through remuneration, which could give rise to a potential conflict of interest and encourage the bank to accept weak SPTs and KPIs.

Many of these concerns also apply to the SLL market. However, in SLLs there is the additional issue that there is no requirement to publish information about the loan because it is a private product.

This is where SLLBs could come in, creating an opportunity to bring greater accountability and transparency to the market.

“Pretty much every major bank has a sustainability-linked loan book, and they’re all under pressure to prove that they’re sustainable,” says Richardson. “An SLLB could be a great way of bringing clarity to that.”

If this all sounds rather like a securitization that is because the technology is very similar. Collateralized loan obligations have historically served as an efficient way to give bond investors access to portfolios of loans, even for very granular asset classes such as small and medium-sized enterprise loans.

Nordea's SLLB framework gives fixed-income investors exposure to SLLs and so drives liquidity to the SLL market.

Specialist ESG data provider ISS has reviewed each of the loans in Nordea’s portfolio against the bank's objectives and has provided a selection of case studies.

The review looks at whether or not each of the loans meets eligibility requirements and ranks them on how well they meet the 'material KPI and ambitious SPT' criteria. Not all the loans assessed by ISS were eligible and so were excluded from the portfolio.

The SLLs that were deemed eligible were ranked as limited, good or robust against relevance, materiality, ability to be benchmarked and the ambition against past performance of the loan KPIs, as well as against sector peers and international targets for the SPTs.

The majority were scored ‘good’, with some listed as ‘limited’ or ‘robust’.

The case studies provided by Nordea include jewellery maker Pandora’s April 2021 five-year (with a two-year extension) €950 million revolving credit facility linked to two KPIs: carbon neutrality in its own operations; and use of only recycled silver and gold, both by 2025.

Others include Norwegian shipping company Wallenius Wilhelmsen’s $800 million loan in August 2022, with KPIs based on its CO2 emissions targets, with the coupon to be assessed and adjusted annually.

Danish paints and coatings supplier Hempel’s April 2022 €1.5 billion SLL was also listed. The loan was linked to four KPIs: reducing Scope 1 and 2 CO2-equivalent emissions by 90% by 2025; reduction of Scope 3 emissions by 70% by 2025; zero waste to landfill from production sites by the end of 2025; and a 25% reduction of red raw materials, also by 2025.

Bankers on Nordea's SLLB deal are confident that similar products will be developed in future.

“No doubt we will see other issuances with this structure,” says Armin Peter, global head of debt syndicate and head of sustainable banking Europe, Middle East and Africa at UBS. “Banks will now have to give consideration to the structure.”

For the team that created the framework, it isn't a question of if but when that will be.

“I'd be surprised to see another SLLB from another issuer before Christmas,” says Jacob Michaelsen, head of sustainable finance advisory at Nordea. “But I would be a bit disappointed if we don't see one by summertime next year.”

Nordic Investment Bank is reportedly exploring the use of an SLLB to finance its own SLL portfolio, following the lead of Nordea’s krona issuances in 2022.

If similar frameworks are adopted by other FIG issuers, ensuring the quality of the external review will be of paramount importance.

“The potential success of this bond in bringing transparency to SLLs relies completely on the independence and quality of the external review,” says Richardson.

While unregulated, ISS is widely viewed as a reliable ESG data provider. It is listed as the best ESG data provider in terms of investor confidence in environmental consultancy ERM’s Rating the Raters April 2023 report.

There is, nevertheless, a potential conflict of interest for ISS because of its role in evaluating both the framework of the bond and the eligibility of SLLs in the funded portfolio.

For Richardson, having a separate external reviewer for the framework and for portfolio eligibility would be an improvement for future issuances.

“That way, the reviewer of the framework could actually give their opinion on the quality of the eligibility assessment, as the product’s ESG credentials will hinge on the quality of the eligibility assessment,” she says.

This would further ensure the quality of the SLLs and the product.

There have been concerns about ESG data providers, not just for SLLBs but also in the SLB market and sustainable investments more broadly.

Unlike rating agencies, ESG data providers are not regulated, neither in the methodology they use to assess ESG credentials nor on how the business handles the conflict of interest created by their funding structure.

In the EU, legislators could require ESG data providers to be registered, be more transparent about their methodologies and separate rating agency business lines from consultancy lines. Legislative discussions on these issues are also taking place in the US and Asia.

In the meantime, investors remain reliant on external reviews.

For SLLBs to grow, improving pricing will also be a key factor. On Nordea’s euro SLLB, there was an eight-basis point concession. This means the deal did not see the price advantage that often comes with green bonds – the greenium.

According to Richardson, this was still true in the secondary market one month after launch. The bond was trading in line with Nordea’s conventional euro issuances rather than its euro green bonds.

However, the concession should not put off future issuers.

“It’s not uncommon for new products to have a concession as investors aren’t familiar with the new product and are getting up to speed with how it works,” says Richardson. “If more banks brought them to market, investors would get comfortable and then pricing could tighten.”

While the deal ended up oversubscribed, investors had questions during the global calls held by Nordea and in one-to-one sessions. According to bankers on the deal, a key one that came up was where the bond would fit in a broader portfolio.

“The conversation definitely lay around where this product would fit: is it suitable for ESG portfolios or should it be considered more like a conventional Nordea bond?” says Stephane Marciel, head of sustainable bonds, debt capital markets, at Societe Generale.

In the end, buyers were a mix of both ESG and conventional Nordea investors.

The development of market practice for the bond – along the lines of the International Capital Market Association's sustainability-linked bond principles – could help bring more clarity and make investors more comfortable with the product. According to bankers on the deal, the conversation about developing standards for SLLBs has already started.

As more banks are expected to come to market with the structure, it is important to note that it won’t be a suitable product for everyone.

Nordea was well-positioned to be the first. It is a familiar name in the Eurobond markets in both green and conventional offerings. The SLLB marks its third visit this year, following a €1 billion issuance in February and a £300 million green bond in April.

Perhaps more important, however, is the bank’s historic position on sustainability. It has been a member of the Net Zero Banking Alliance since 2019 and has committed to reaching net zero by 2050, despite the typically high exposure of Nordic banks to fossil fuels.

Relative to its competitors, Nordea’s investment in fossil fuels also suggests an effort to improve its sustainability profile. According to a Banking on Climate Chaos August 2023 report, Nordea has reduced its investment in fossil fuels from $2.85 billion in 2016 to $927 million in 2022. It ranks as the 52nd largest lender in fossil fuels, a lower exposure than competitors like ING (28th) and BoC (17th).

“[The funding] framework would work for many different clients, but it’s not a fit for anyone and everyone,” says UBS’s Peter. “It all starts with the strategic approach to sustainability as a financial institution, if you’re not living this strategy as a bank, then it’s not the right fit.”

SocGen’s Marciel agrees.

“Issuing a bond like this should not be seen as an opportunistic approach to the market,” he says. “It must be a reflection of the overall ambition of the sustainability strategy.”

So where could we see this kind of issuance next from a FIG issuer?

“Any national champion in the UK (Lloyds, NatWest), Europe (BNP, UniCredit, Commerzbank) and Australia (the big four) would be suitable candidates for issuing this bond,” says one banker close to the deal. “In particular, those that have a defined sustainable finance lending strategy.”