Understanding dynamics between sustainable and traditional debt

18 minute read

As the Sustainability-Linked Bond (SLB) market expands, investors are given more choice as to the products they use to signal their credit and sustainability outlook.

We examine the relationship between sustainability and credit performance, and explore how investors can convey their views using SLBs compared to traditional bonds.

The defining feature of the SLB is an option-like pay out tied to sustainability performance, which will lead to differing behaviour from traditional bonds in some situations. SLBs provide protection if poor sustainability performance results in the issuer missing a Sustainability Performance Target (SPT). SLBs thus provide a hedge for investors, mitigating downside risk, and will outperform in this scenario. If, on the other hand, strong sustainability performance drives credit improvement, the hedge (which has been paid for) is unnecessary and so an SLB is less valuable. Traditional bonds could be used for a more leveraged position if an investor has a strongly bullish view on the issuer.

We include three case studies on issuers with extensive credit curves comprising a variety of instruments. In these examples, investors have a choice of products and so take a position on credit and sustainability when they buy. We apply our option pricing model to help analyse value in these situations.