Notes on Risk-Neutral Pricing of SLBs and Step-down Structures

Authors: Ulf Erlandsson (Anthropocene Fixed Income Institute), Stephanie Mielnik (Anthropocene Fixed Income Institute), Josephine Richardson (Anthropocene Fixed Income Institute), Cedric Rimaud (Anthropocene Fixed Income Institute)
Presenter: Ulf Erlandsson (Anthropocene Fixed Income Institute)
Abstract: Sustainability-Linked Bonds (SLBs) have quickly risen to as a new way to finance transition plans encompassing a full corporate structure rather than just specific asset. This paper analyses SLBs through a risk-neutral present value scenario approach, assuming that the discounted, probability-weighted cashflows in an SLB should equate to those of an equivalent vanilla bond (EVB). 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 allows us also to back-out market-implied step-up probabilities and can be used to adjust a structure to accommodate a sought-after lower cost-of-capital for the issuer. When 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. Our results outline how SLBs can be used by investors to provide conditional lower cost-of-capital, but without breaching fiduciary duty, and thus potentially become an important tool for fixed income markets to drive climate transition.
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