Notes on Risk-Neutral Pricing of SLBs and Step-down Structures

16 Pages Posted: 29 Oct 2022

See all articles by Ulf Erlandsson

Ulf Erlandsson

Anthropocene Fixed Income Institute

Stephanie Mielnik

Anthropocene Fixed Income Institute

Josephine Richardson

Anthropocene Fixed Income Institute

Cedric Rimaud

Anthropocene Fixed Income Institute

Date Written: October 26, 2022

Abstract

This paper analyses Sustainability-Linked Bonds (SLBs) through a risk-neutral present value scenario approach. By assuming that the discounted, probability-weighted cashflows in an SLB should equate to those of an equivalent vanilla bond (EVB), several conclusions around this new type of financing instrument are derived. We show how, in a risk-free setting, a step-down SLB must by necessity offer a coupon above that of the equivalent vanilla bond, and vice versa for step-ups. The model also allows us also to back-out – holding other variables fixed - market-implied step-up probabilities. It can alternatively be used to adjust a structure to accommodate a sought-after lower cost-of-capital for the issuer. Expanding the model to include various risk perceptions: we show that the dynamics change such that a step-down SLB may actually price with a coupon lower than a traditional bond, if the sustainability linkages are correlated with improved credit quality/higher repayment probabilities. We illustrate this by calibrating a step-down SLB to rating based spread curves.

Keywords: Fixed income, Sustainability-linked bonds, Pricing

JEL Classification: G12, Q50

Suggested Citation

Erlandsson, Ulf and Mielnik, Stephanie and Richardson, Josephine and Rimaud, Cedric, Notes on Risk-Neutral Pricing of SLBs and Step-down Structures (October 26, 2022). Available at SSRN: https://ssrn.com/abstract=4258897 or http://dx.doi.org/10.2139/ssrn.4258897

Ulf Erlandsson (Contact Author)

Anthropocene Fixed Income Institute ( email )

c/o Erlandsson
Fogdev 4
Saltsjo-Duvnas, NA 13150
Sweden

HOME PAGE: http://www.anthropocenefii.org

Stephanie Mielnik

Anthropocene Fixed Income Institute

Josephine Richardson

Anthropocene Fixed Income Institute

Cedric Rimaud

Anthropocene Fixed Income Institute

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
354
Abstract Views
1,285
Rank
156,567
PlumX Metrics