FAQ – Toxic bonds

Bonds are a debt security, like an IOU, where a corporation, government or other entity (bond issuer) sells the bond to many investors (bondholders) which lend money to the entity for a set period of time (maturity period) in exchange for regular interest payments (coupon rate). After the maturity period, the principal (also known as face value or par value) is repaid to the bondholder.

When a company wants to raise money they have two choices: equity financing or debt financing. Equity financing means giving up a percentage of ownership in the company by selling shares. Debt financing means companies have to pay back the funds over an agreed time period, plus interest. Companies pursuing debt financing can choose one of two routes: a loan from a bank or other financial institution, or by issuing bonds.

The primary market is where companies issue bonds and seek investors for their debt. The primary market should be thought of as the point of maximum leverage for increasing cost of capital to companies or disrupting bond issuance entirely. Financial institutions must stop giving fresh capital to fossil fuel companies via new bond issuance – or, as we say, deny new debt.
Bonds are also traded on the secondary market (like shares). Bonds traded on the secondary market do not impact the current interest rate or face value of the bond when it reaches maturity. Thus, investors divesting from their existing bondholdings has less of a direct impact on money flowing to the issuing company, although it can send helpful market signals and lead a fossil fuel company to pay out higher interest rates on future bonds.

Issuing companies engage banks or other firms to advise and assist during the process. Banks enhance the credibility of the offer and ensure a higher chance of successfully issuing a bond. An investment bank’s role involves managing all aspects of the issuance process, including structuring the bond, preparing the prospectus, managing the roadshow and investor meetings, pricing, allocation and the listing process.

In a large bond deal a group of banks will not only advise a company, but can each take a chunk of the bond deal (the “book”) and assume the financial risk for selling this onto investors. Banks will pocket the profits from the transaction. Companies seek out known and experienced investment banks for this role.

The bond prospectus is prepared in the issuance process, it is a legal document detailing the terms of the bond, the issuer’s financial situation, and the potential risks associated with the bond. It’s prepared with the help of the underwriters and is essential for investors to make informed decisions.

Credit rating by a known agency is also important. The three large global credit rating agencies (CRAs) are S&P, Moody’s and Fitch. In certain jurisdictions local rating agencies are also well established and dominate those markets. CRAs evaluate the issuer’s creditworthiness and assign a rating to the bonds. A higher rating signifies lower credit risk, implying the issuer has a strong capacity to meet its financial commitments.

The last part of the bond issuance process is marketing and selling the bonds. The issuing company and its banks gauge market appetite under the proposed bond terms. The banks use their networks to find buyers. This often involves roadshows which include presentations and one-on-one meetings with potential investors in which they are introduced to the company. If not enough investor interest is achieved, the issuer and the investment bank may revise and re-launch the bond.

The vast majority of corporate bonds on the market today are standard, unlabelled instruments — often referred to as “vanilla” bonds. These bonds provide companies with unrestricted capital (i.e. no conditions on how the funds are used).

A smaller share of bonds are marketed as “sustainable” through various labels that suggest alignment with environmental or social goals. These are commonly grouped under four main categories: green, social, sustainability, and sustainability-linked bonds. Labelled bonds are estimated to make up less than 15% of global corporate bond issuance in 2024.

• Green bonds, the main category of sustainable bonds, are use-of-proceeds bonds. The company issuing them promises the investor that the funds will be allocated exclusively to environmentally beneficial projects — such as renewable energy or energy-efficient infrastructure. However, with little supervision, green bonds cover a multitude of realities, including the financing of non-green projects and the emission of bonds by polluting companies.
• Social and sustainability bonds also rely on the use-of-proceeds model. Social bonds fund projects targeting issues like public health, education, or housing. Sustainability bonds combine environmental and social goals. Concerns are similar to green bonds.
• Sustainability-linked bonds (SLBs), on the other hand, are not tied to how the proceeds are used, but instead to the company’s achievement of sustainability performance targets, typically through key performance indicators (KPIs). SLBs finance the issuing entity as a whole. This means that the company is free to use the money however it wants as long as it achieves predefined sustainability objectives set by… itself. However, this flexibility is in fact a double-edged sword. It’s not just the sustainability objectives and the indicators to measure them that must be ambitious and meaningful to the issuer’s activities – rather, the company’s entire strategy must be aligned with what science recommends for achieving the 1.5°C target. Several recent issuances demonstrate that even highly destructive companies can label their bonds as “sustainable-linked” by only committing to marginal efforts to improve their own performance or by making vague promises.

Overall, while sustainable finance instruments are expanding, the limited scale, inconsistent standards, and persistent loopholes undermine their potential to redirect capital away from fossil fuels and toward a just and credible transition. Without stricter regulation, robust transparency, and exclusion of harmful actors, the labelled bond market risks serving more as a public relations tool than a genuine lever for climate action. Things such as weak targets for SLBs or green bonds freeing up capital for fossil fuel expansion have been widely critiqued.

To limit global warming to 1.5 degrees there is no room for new fossil fuel projects. Every time investors buy new bonds from fossil fuel developers they are contributing to those expansion plans. The course of action therefore is clear: financial institutions must deny new debt to companies developing new fossil fuel projects.

In priority:

Investors – pension funds, insurers and asset managers – must make new investments in bonds issued by fossil fuel developers conditional on them ending their fossil fuel expansion plans, for all assets under management. They should commit to voting at AGMs against strategic management-proposed resolutions until companies end their fossil fuel expansion plans (such as reelections of directors, approval of the discharge of the boards of directors, and approval of the remuneration of directors and top executives). An assessment of the climate practices of the biggest asset managers can be found here.

Banks should:

• Adopt a policy that ends general purpose corporate financing towards companies involved in the expansion of coal, and/or upstream and midstream oil and gas. Such a policy should also restrict financial support to companies involved in gas power development. The policy should be applied to both lending and capital market services.
• Implement adequate decarbonization targets to reduce, and ultimately phase-out, all financing to fossil fuels. These targets shall cover all material financial services provided to companies involved in any segment of the fossil fuel value chain. Targets shall differentiate fossil fuel subsectors, with for each a clear reduction pathway (i.e. interim target and phase-out date), and may also be set for each financial service (e.g. specific targets for both the reduction of credit exposure reduction and that of facilitated amounts on the capital markets).