Valuation and Design of Sustainability-Linked Bonds

Abstract

Sustainability-linked bonds (SLBs) offer coupon payments that increase if key performance indicators do not reach sustainability performance targets. In both a risk-neutral and a consumption-based pricing framework, we find that fair issue yields of SLBs, and hence their financing costs, are non-monotonic in the ambition of the sustainability targets. Thus - contrary to common perceptions - more ambitious targets do not necessarily indicate a higher sustainability quality; rather, an opportunistic issuer may set more ambitious targets in order to lower financing costs. We also show that an issuer that chooses higher penalty payments may do so in order to better exploit investor preferences for sustainable assets.

Keywords: sustainability, bonds, security design, coupon step-up, default

JEL Classification: G12, G32, Q54, Q56