By assuming that the discounted, probability-weighted cashflows in an SLB should equate to those of an equivalent vanilla bond, 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 and 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.