The Economics of Sustainability Linked Bonds

Abstract

We develop a framework to understand the incentive structure and pricing of sustainability-linked bonds (SLBs). It provides conditions under which SLBs are incentive compatible for firms. We propose a novel mispricing measure for SLBs. Using the model and mispricing measure, we derive and test several empirical predictions. We show that overpriced SLBs experience negative returns in the secondary market after issuance. When firms issue overpriced SLBs, the stock price reaction at issuance is significantly positive, consistent with a wealth transfer from bond- to shareholders. Finally, we document a significant nonlinear relationship between the mispricing measure and firms' ESG ratings.

Keywords: ESG investing, sustainability linked bonds, security design, managerial incentives, mispricing