Sustainability-Linked Bonds

Notes on risk-neutral pricing of SLBs and step-down structures

Written by Ulf Erlandsson, Stephanie Mielnik & Josephine Richardson

This technical note analyses Sustainability-Linked Bond (SLB) structures using a binomial approach and with a particular focus on step-down structures. More specifically, this paper analyses 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, 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.

Link to article at SSRN

About the authors

Ulf Erlandsson

Ulf Erlandsson

Founder, Board member

Dr Ulf Erlandsson founded the Anthropocene Fixed Income Institute and was its first CEO. A pioneer of climate-focused fixed income portfolio management, he was named Environmental Finance’s Bond Personality of the Year 2022.

Josephine Richardson

Josephine Richardson

Managing Director, Head of Research

Based in London, Jo leads AFII’s research and a global team supporting fixed income investors as they align their portfolios with climate and sustainability goals. She joined AFII after 18 years in fixed income markets at JPMorgan.

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