Transition linkers

Abstract

This paper introduces a new type of a bond, a transition linker, which allows investors to hedge risky asset return correlation with national energy transition progression. Sharing features with inflation linkers, convertibles and other performance-linked bonds, the transition linker is a sovereign bond where the coupon level adjusts in several steps if the issuer under-or outperforms vis-a-vis externally committed transition decarbonisation targets. We show how the transition linker can be useful in asset allocation with the investment hypothesis that risky asset returns will be lower and/or more volatile in case of an unsuccessful transition. At the same time, the linker provides cost-of-capital incentives for the issuer (the government) to generate policies that increase the transition likelihood. The linker can also be used to derive implied probabilities of reaching transition targets, providing investors, the general public and the issuers themselves important real-time information on transition progress. The paper develops a pricing approach for transition linkers and discusses various structural implementations to accommodate traditional mainstream fixed income books. Finally, it analyses a hypothetical transition linker format for the case of Japan, an already active sovereign issuer of inflation linked and transition bonds.

Keywords: government bonds, fixed income, energy transition

JEL Classification: G13, E44